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To understand unsecured loans, you must first understand the underlying concept of secured loans. A secured loan requires borrowers to designate valuable personal property as collateral. If the borrower defaults on the loan, the lender has the right to take possession of the collateral property and sell it to recoup a bit of the outstanding loan balance. Therefore, the loan is "secured" due to the fact that the lender has a form of insurance against default losses.
An unsecured loan does not require any property to be put up as collateral. This type of loan relies solely on a legal agreement between the lender and borrower to enforce the repayment schedule. Lenders of unsecured loans must go through civil court to obtain a judgment for payment on a defaulted account, which takes much more time and is much less cost-efficient than taking possession of property.
At first glance, it may seem that unsecured loans
favor borrowers more than lenders, but these loans feature distinct advantages for lenders, as well.
Advantages and Disadvantages
Unsecured loans generally carry a higher interest rate and fee structure than secured loans, due to the higher risk taken on by lenders. This can be seen as a disadvantage for borrowers, since it allows lenders to invest in higher risk loans with higher profit potential.
The main advantage of unsecured loans to business borrowers is the absence of the collateral requirement. By not placing property up as collateral, unsecured loans offer protection to a business facing financial hardship because the business can continue operating or sell property to pay creditors.
Unsecured loans that end up in default are more likely to go through an extensive collections process that can double the outstanding balance and harm a business's credit history. Make payments on unsecured loans a priority for your business, because lenders will definitely make collections a priority if you fall into default.