How Does an Unsecured Personal Loan Work?

The Borrower Shops and Applies for a Loan

When a borrower wishes to take out an unsecured loan, she first performs research either on the Internet or by making personal inquiries to financial institutions. Because interest rates, terms and other variables are different from bank to bank, shopping around ensures the best available lending arrangement. Once a suitable loan arrangement is found, the borrower submits an application explaining why the bank should lend her money based solely on her promise to repay.

The Bank Processes the Application

When an application is received, bank personnel use a combination of electronic tools and personal experience to evaluate the request. Factors such as the borrower's past performance in repaying other unsecured debts (such as credit cards and personal loans) weigh heavily in the bank's decision. Additional factors, such as secured payments made on time, the borrower's length of employment, and the borrower's references are also considered. Some banks may be more inclined to approve applications from homeowners than from renters since the homeowner is tied to a property she can not abandon without a lengthy sales process. Because the bank does not have a hard asset to retrieve should the borrower default, the bank's risk is somewhat increased should it approve the loan. Since interest rates are directly tied to the risk incurred by the bank, unsecured loans are often assigned a higher interest rate.

When all factors are available, a loan officer weighs the risk of lending money to the borrower against the potential profit the bank would realize if the lender were to repay the loan in full. This consideration ultimately determines whether the loan is approved.

The Bank Funds and Services the Loan

If the loan application is approved, the bank credits the requested amount to the borrower's account, sends the borrower a payment book and begins collecting monthly payments. The interest due to the bank is pre-calculated into the monthly payment, ensuring the bank realizes a profit as quickly as possible. If the borrower should miss a payment, the bank will contact her and, if necessary, work with her to ensure the loan is re-payed. Since the bank can not repossess any physical item securing the loan, many institutions exhibit a measure of flexibility to ensure the borrower continues making payments. Should the borrower default on the loan, the bank will report the default to credit reporting bureaus and, depending on the size of the loan, begin legal action to force repayment. If the borrower still does not comply with the payment plan, the bank may attempt to recover the debt through garnishment of wages or liens on any property owned by the borrower.