What Is a Signature Loan, and How Does It Work?

If you’re looking for a loan that doesn’t require you to have collateral, this could be the right move for you.

In the world of personal finance, signature loans stand out as a unique and straightforward borrowing option. Also known as "good faith loans" or "character loans," these financial products offer a way for individuals to secure funds based primarily on their creditworthiness and promise to repay.

What is a signature loan?

A signature loan is a type of unsecured personal loan that is backed solely by the borrower's signature as a promise to repay. Unlike secured loans that require collateral, such as a car or house, signature loans rely on the borrower's creditworthiness and income. This makes them an attractive option for those who need funds but don't want to risk their assets.

Signature loans typically come with fixed interest rates and set repayment terms. This means borrowers know exactly how much they'll need to pay each month and for how long. The loan amounts can vary widely, often ranging from a few thousand dollars to tens of thousands, depending on the lender and the borrower's qualifications.

How signature loans work

The process of obtaining a signature loan is pretty straightforward. To start, a potential borrower applies for the loan, typically providing information about their income, employment, and existing debts. The lender will also perform a credit check to assess the applicant's credit history and score.

If approved, the lender will offer loan terms, including the interest rate, loan amount, and repayment period. These terms are largely based on the borrower's creditworthiness and income. Borrowers with excellent credit scores and stable, high incomes often qualify for the best rates and terms.

Once the borrower accepts the terms and signs the loan agreement, the funds are typically disbursed quickly, often within a few business days. The borrower then begins making regular payments according to the agreed-upon schedule until the loan is fully repaid.

Advantages of signature loans

Signature loans offer several benefits that make them attractive to many borrowers:

1. Flexibility: The funds from a signature loan can be used for almost any purpose, from consolidating debt to funding a major purchase.

2. Quick approval: With minimal documentation required, signature loans often have a faster approval process compared to secured loans.

3. No collateral required: Borrowers don't need to put up any assets as collateral, reducing the risk of losing personal property.

4. Fixed payments: The fixed interest rate and set repayment term make budgeting easier for borrowers.

Potential drawbacks of signature loans

While signature loans offer many advantages, they also come with some drawbacks to consider.

1. Higher interest rates: Because they're unsecured, signature loans typically carry higher interest rates than secured loans.

2. Credit score impact: As with any loan, failure to make timely payments can negatively impact the borrower's credit score.

3. Qualification challenges: Those with poor credit or inconsistent income may find it difficult to qualify for a signature loan, or may face less-favorable terms. Across the board, loan rejections are up—here's what you can do to improve your approval odds.

Who should consider a signature loan?

Signature loans can be a good option for individuals with good credit who need funds for a specific purpose and prefer not to use collateral. They're often used for debt consolidation, home improvements, or unexpected expenses.

However, it's crucial for potential borrowers to carefully consider their ability to repay the loan and compare offers from multiple lenders to ensure they're getting the best possible terms.

According to debt attorney Leslie Tayne, the best signature loan rates today can be found for as low as 5% to 6%, though many lenders start their rates around 7% to 9%. Tayne says these rates are reserved for the most creditworthy borrowers or those with “very good” credit scores of around 740 and up. "These borrowers have demonstrated past behaviors that indicate they are low-risk," explains Tayne. "They generally pay their bills on time, maintain low debt balances, and don’t rely too heavily on credit."

At the other end of the spectrum, borrowers with poor credit can expect to pay upwards of 30% for an unsecured personal loan. These borrowers have had issues with missed payments in the past and even collections or bankruptcies. "Because of these past problems managing debt," says Tayne, "they present a high level of risk for lenders and face subprime interest rates."

The bottom line

Signature loans offer a straightforward borrowing option for those who prefer not to put up collateral. By understanding how these loans work, their advantages, and potential drawbacks, borrowers can make informed decisions about whether a signature loan is the right financial tool for their needs. As with any financial decision, it's wise to carefully consider one's personal financial situation and consult with a financial advisor if needed before taking on new debt.