What is a Signature Loan?
Signature loans are one of the most popular forms of personal lending, providing borrowers with a lump sum upfront in exchange for installment repayments. Depending on the lender, these loans can also be known as unsecured personal loans, good faith loans, or character loans.
In this article, we’ll take a look at how signature loans work, how they differ from other loans, and when they might be the best fit for your financial needs.
How Does a Signature Loan Work?
Like all borrowing, the process for taking out a signature loan is broken down into three stages: application, disbursement, and repayment.
When you apply for a signature loan, prospective lenders will closely evaluate your credit risk. Since signature loans require no collateral, repayment depends entirely on the borrower’s ability and willingness to service the debt.
Signature loan lenders usually focus on your credit score as the primary basis of evaluation, but other factors can matter too. Depending on the lender, your employment history and debt-to-income ratio may also play an important role. If you’re approved for the loan, the strength of your application will also help determine the interest rate you’re offered.
Signature loans are typically disbursed in a lump sum, meaning you receive the entire amount upfront. These loans usually come with few restrictions on how the money can be spent, meaning you’re free to use the funds to accomplish a diverse array of financial goals.
Signature loans are most commonly installment loans, meaning borrowers make fixed periodic payments until their loan balance is cleared. Monthly payment schedules are standard.
Depending on the terms of the loan, repayment usually takes between one and five years. While fixed monthly payments are easier to budget for, they also reduce your financial flexibility. Moreover, although prepaying a signature loan may be possible, doing so often incurs extra fees.
What Makes a Signature Loan Different from a Personal Loan?
Signature loans come with certain similarities and differences to more familiar forms of borrowing. We can understand what makes a signature loan unique through both its unsecured and installment nature.
Signature loans are unsecured
Unlike many popular loan types, signature loans require no collateral. Mortgages and car loans, for instance, both require assets to serve as security.
While the structure isn’t as common, some forms of personal loans are also secured. Certain borrowers, for example, may require you to put up securities or a savings account as collateral. Signature loans, however, just require you to have adequate credit, eliminating the need for collateral entirely.
Although unsecured lending tends to result in higher interest rates than secured lending, it also means that lenders can’t simply seize one of your assets if you fail to repay the loan. Similarly, unsecured loans can allow individuals with few assets to access the financing they need.
Signature loans are installment credit
Signature loans are made on an installment basis, meaning you receive cash upfront and must make fixed periodic payments. In this sense, signature loans are similar to mortgages and car loans, which are both installment credit.
Unsecured personal lending on a non-installment basis does exist – most notably through credit cards, a form of revolving credit. While credit cards offer flexibility concerning disbursement and repayment, they also tend to come with higher interest rates.
Since signature loans are different from other forms of debt, the situations in which you would use them also differ. Let’s look at the scenarios in which taking out a signature loan could be a good strategy.
What Are the Best Ways to Use a Signature Loan?
Unlike some other forms of borrowing, which ascribe strict restrictions to how you can use the funds, signature loans are designed to be accommodating. Generally, they can used for a variety of purposes, including:
- Debt consolidation – Paying off higher-interest loans to begin a sustainable path out of debt.
- Medical expenses – Financing emergency medical expenses that you can’t cover out of pocket.
- Home improvements – Paying for home renovations or repairs, especially in response to unforeseen damage.
While signature loans can certainly be a flexible option, they may not always be the best path to accomplishing your goals. In particular, borrowing against major assets can often be a cheaper source of financing.
Based on the latest Federal Reserve data, the average personal loan interest rate is around 12%. That’s certainly lower than the rate offered on other forms of unsecured lending like credit cards, which sits at around 20%. But it’s also higher than many forms of secured lending, like car loans (around 8% as of August 2023) and mortgages (around 7% as of November 2023).
If you’re paying for a major expense that you can’t cover out of pocket, turning to secured lending like a home equity loan or securities-based line of credit should usually be the first step. Because the interest rate on such loans is typically cheaper, they’ll likely be better for your financial health.
Still, there are plenty of good reasons a borrower could turn to a signature loan instead.
Reason 1: Few suitable assets
While secured lending might be cheaper than unsecured lending, not everyone has assets to borrow against. Similarly, not everyone will feel comfortable risking their assets by pledging them to a loan. In these cases, the strongest thing a borrower can offer may be their credit history.
Reason 2: Prefer fixed repayments
Many secured lending products are offered on a revolving basis, meaning you withdraw funds when you need them and repay funds as you can. Some people prefer fixed repayment schedules, which can make budgeting easier.
Reason 3: Simplified application process
The application process for a signature loan is often relatively straightforward since it doesn’t require collateral evaluation. If you need funds quickly, the simplicity of the loan application process can be a real difference-maker in which option you choose.
Signature loan: Things to consider
If you decide that a signature loan is right for you, you’ll want to find the lender best suited to your situation. As you weigh your options, here are some considerations to help you make the best choice.
- Credit factors. If you don’t have the best credit score, looking for lenders that consider factors like income or employment history may help get you the best interest rate.
- Term length. If you will need a little extra time to repay the loan, look for a lender that offers suitable repayment terms.
- Loan amounts. Depending on your credit evaluation, the amount of funding you’re eligible for may vary from lender to lender.
- Extra fees. Some lenders may charge origination fees or late payment fees, which can impact the total cost of the loan.
Remember, different lenders have different criteria. Ensure you cast a wide net in your signature loan search to find the best fit for your situation.