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What is a signature loan, what is it used for & how is it different?
Learn all about signature loans, when and how to use them to make informed financial decisions.
What is a signature loan?
A signature loan — sometimes known as a “good faith loan” or “character loan” — is a fixed-rate personal loan backed by the borrower’s signature as the promise to pay. Banks and financial companies offer signature loans if they deem the borrower has enough income and a good credit history. The interest rates on this type of loan are typically higher than other forms of credit due to the lack of collateral.
Key Takeaways
- A signature loan relies solely on the borrower's signature and commitment to repay as collateral.
- Interest rates for signature loans tend to be higher compared to other loans, primarily because of the lack of collateral.
- The borrower's income and strong credit history are key factors for lenders when approving signature loans.
How does a signature loan work?
When evaluating a signature loan application, lenders generally seek a strong credit history and adequate income to ensure the borrower can repay the loan. Occasionally, they may ask for a co-signer, who would only be responsible if the primary borrower fails to make payments. These factors, credit history, income and credit score, will also determine the amount you can qualify for and the interest rate.
Signature loans fall under the category of unsecured term loans. The term "unsecured" indicates that these loans do not require any physical assets as collateral, unlike mortgages or auto loans. Meanwhile, "term" signifies that the loan is repaid through regular monthly installments over a specified duration.
If you do qualify, the application process is quite simple:
1) Fill out an application with your personal and financial details.
2) The lender assesses your credit to determine if you qualify and what your interest rate will be.
3) If you’re approved, funds are transferred directly to your bank account.
As mentioned before, since these loans aren't backed by collateral, interest rates tend to be higher than those for secured loans, although they are usually more affordable than credit card rates.
The length of the loan can vary from 3 to 96 months, based on the amount and the lender’s policies, with smaller loans typically requiring shorter repayment periods. Your monthly payments will consist of both principal and interest.
How is a signature loan different from other types of loan?
Signature loan vs personal loan
A signature loan is essentially a type of personal loan rather than something entirely distinct. The term "personal loan" encompasses a wide range of loan types, including secured loans, unsecured loans, debt consolidation loans, and variable rate loans. Specifically, a signature loan is classified as an unsecured personal loan because it does not require any collateral.
Signature loan vs revolving credit
There are 2 main differences between signature loans and revolving credit: speed of funding and closing the account. Applying for traditional or revolving credit loans often leads to delays in funding as the lender reviews the borrower’s credit history and assesses their qualifications. However, signature loans provide faster access to funds, allowing borrowers to address their financial needs more promptly.
Moreover, once a signature loan is fully repaid, the account is closed, and the borrower must apply for a new loan if they need more funds. But a revolving credit account allows borrowers to repay their debt while keeping the credit line open until either party decides to terminate the account.
5 main uses of signature loans
Relying solely on the borrower’s promise to repay signature loans can be used for:
- Debt consolidation. This involves combining multiple debts into a single loan for easier management. If you have multiple high-interest debts, like credit cards, you can use a signature loan to consolidate them into a single payment with a lower interest rate. This can help decrease your overall interest costs and allow you to pay down your debt more quickly.
- Emergency expenses. This covers unexpected costs like medical bills or car repairs. Unexpected expenses can arise at any moment, often catching us off guard. Whether it's a sudden medical emergency, urgent car repairs, or home maintenance issues, these financial surprises can disrupt even the best-laid budgets. A signature loan can provide you with the funds needed to cover these expenses.
- Home improvements. This is for financing renovations or repairs without requiring collateral. Major renovations are often financed through a Home Equity Line of Credit (HELOC), which allows homeowners to tap into the equity they’ve built in their property. By choosing a signature loan, you can fund renovations or repairs without having to use your home as collateral, unlike with home equity loans. Additionally, you won’t diminish your home equity, which is advantageous if you intend to sell your home in the future.
- Education costs. This is used to fund tuition fees and living expenses for college or vocational training. A signature loan can be an advantageous option for education expenses, as it provides access to funds based solely on creditworthiness without requiring collateral. They often come with quicker approval times, which allows for quick funding of tuition, books, and living expenses, helping students focus on their studies without financial stress.
- Weddings or special events. This is used to finance celebrations without relying on high-interest credit cards. A signature loan provides a convenient way to finance weddings or other such big events that sometimes can occur even unexpectedly, offering quick access to cash without requiring collateral. This flexibility enables couples or event planners to secure the funds they need promptly, ensuring that special moments can be celebrated without delay or the added stress of finance.
However, it’s important to note that signature loans should not be used for investments, illegal activities, gambling, or luxury items.
Pros and cons of a signature loan.
Before opting for a signature loan, it’s important to weigh its advantages and disadvantages. Signature loans offer quick funding, no collateral requirement, and flexible use of funds, with fixed monthly payments that can aid in budgeting. With this in mind, borrowers should be aware of potential fees and high interest rates, especially for those with lower credit scores. Understanding these factors is essential in determining if this type of loan aligns with your financial needs. Here are the pros and cons of a signature loan:
Pros
- Quick funding, often available within a short period.
- No collateral needed, reducing the risk for borrowers.
- Flexible use of funds for various purposes.
- Fixed monthly payments, making budgeting easier.
- May help build or improve credit history if payments are made on time.
Cons
- Lenders may charge fees such as origination fees or prepayment penalties.
- Potentially high interest rates, especially for borrowers with lower credit scores.
- Limited loan amounts compared to secured loans.
- Approval is based on creditworthiness, so borrowers with lower credit scores may face higher interest rates or rejection.
- Defaulting on the loan can damage credit scores and lead to collection efforts by the lender.
Signature loan FAQs
Who uses a signature loan and why?
Historically, people with low credit scores tended to take out signature loans. However, with lower interest rates than credit cards and higher loan maximums, many people with good credit are also starting to take out signature loans for anything from home improvements to unexpected expenses. This type of loan can also be a great way to consolidate and pay off debt if you qualify for a signature loan with a lower APR than your combined debts.
Who is eligible for the signature loan?
Since signature loans are considered “unsecured,” with your signature being the only collateral, lenders want to ensure your ability to repay. They’ll review the documents needed for the loan, examine your credit score and history, and debt-to-income ratio before approving your application.
Where can I get a signature loan?
Several financial institutions might offer signature loans. The most common lenders are:
- Banks
- credit unions
- online lenders
If you already have a relationship with a bank you could try there first, but many people choose online lenders as it's usually faster and you can easily check if you prequalify without harming your credit score.
What is an open-end signature loan?
An open-end signature loan is a type of revolving credit that allows borrowers to access funds up to a pre-approved credit limit. Unlike traditional installment loans, which provide a lump sum of money upfront, open-end signature loans allow borrowers to borrow, repay, and borrow again repeatedly, much like a credit card.
Make sure you talk with legal counsel before making any financial decisions about signature loans.
Simplify the loan process.
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