What is the primary characteristic of an unsecured loan?

The primary characteristic of an unsecured loan is that it is based on creditworthiness. This means that lenders evaluate the borrower's credit history, income, and overall financial situation to determine the likelihood of repayment. Because there is no collateral backing the loan, the lender relies heavily on the borrower's credit profile to make their lending decision.

If the borrower defaults on an unsecured loan, the lender does not have any specific asset to claim, which elevates the risk for the lender. As a result, unsecured loans often come with higher interest rates compared to secured loans, where collateral reduces the lender's risk.

In contrast, collateral is a defining feature of secured loans, where asset backing is essential for loan approval. It should also be noted that unsecured loans can come with interest, contrary to the suggestion that they have no interest, and they can be provided by various financial institutions, not just banks. Thus, understanding that unsecured loans rely primarily on the borrower's creditworthiness is crucial for effectively differentiating between loan types in the context of banking and finance.