You have undoubtedly heard the terms "loan" and "mortgage" used interchangeably if you are starting the thrilling process of purchasing a new house. Although a mortgage is a form of loan, the two are not always interchangeable. Let's examine how loans and mortgages operate.
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| Loan vs. Mortgage |
What is a loan?
A financial arrangement between two people is called a loan. The borrower receives funds from the lender in return for repaying the principal plus interest on the loan. The borrower consents to assume the debt and pay it back according to the conditions set by the lender.
Term loans and revolving loans are two examples of the various types of loans. These loans may be secured or unsecured, and they may be taken out for business or personal use. Each type is employed in various funding conditions and has unique advantages and downsides.
Term loans and revolving loans are two examples of the various types of loans. These loans may be secured or unsecured, and they may be taken out for business or personal use. Each type is employed in various funding conditions and has unique advantages and downsides.
When you take out a loan, you commit to repaying it over time with interest. Generally speaking, a term loan requires set payments over a predetermined length of time. You can take out money from a revolving loan up to a certain credit limit, and you can take out more as you pay it back.
What is a mortgage?
One kind of loan is a mortgage, however the conditions of the loan are linked to your house or property. Because the mortgage will be registered on your home's title and your home or property will be used as security, a mortgage is regarded as a secured loan. The lender will therefore be legally entitled to seize and sell your property if you are unable to fulfill repayment obligations. Foreclosure is the term for this procedure.
You can use a mortgage to buy or refinance a new home or property, as well as to access your existing home's equity for other uses. Purchases of homes are sometimes quite costly, and the majority of borrowers lack the entire amount of money required up front. A financial background check is used by lenders to decide whether to offer a mortgage. Among other things, they consider your income, debt-to-income ratio, and credit score. In order to ascertain the property's value, which will affect the amount they can offer you under the mortgage, lenders typically also get an appraisal.
Financial and Legal Definitions
Financially speaking, loans are agreements made between people, organizations, and/or businesses whereby one party lends money to another with the understanding that the money would be returned, typically with interest, within a predetermined period of time. When someone with good credit wants to establish a business, buy a car, or buy a house, banks usually lend them money, which they then pay back over a certain period of time. Lending and borrowing also take place in a number of other ways. Peer-to-peer lending exchange services such as Lending Club let users to lend modest amounts of money to many others, and borrowing money for small purchases is a frequent practice.
The terms of a loan agreement and the type of loan—such as a mortgage—determine how a loan is regarded under the law. These agreements, which are governed and enforced by the Uniform Commercial Code, provide information regarding the terms, interest rates, and repayment obligations of the loan as well as the consequences of default and missing payments. The goal of federal laws is to shield debtors and creditors from monetary harm.
A formal loan arrangement is generally recommended since financial issues may be resolved more readily and fairly with a written contract than with an oral one, even though people commonly borrow and lend on smaller scales without a contract or promissory note.
The terms of a loan agreement and the type of loan—such as a mortgage—determine how a loan is regarded under the law. These agreements, which are governed and enforced by the Uniform Commercial Code, provide information regarding the terms, interest rates, and repayment obligations of the loan as well as the consequences of default and missing payments. The goal of federal laws is to shield debtors and creditors from monetary harm.
A formal loan arrangement is generally recommended since financial issues may be resolved more readily and fairly with a written contract than with an oral one, even though people commonly borrow and lend on smaller scales without a contract or promissory note.
Loan and Mortgage Terminology
A number of words are frequently used while talking about mortgages and loans. It's critical to comprehend them prior to lending or borrowing.
- Principal: The total amount borrowed less any interest that has not yet been paid back. For instance, the principal is $2,000 if a person borrows $5,000 and repays $3,000 of it. It doesn't account for any interest that might be owed on top of the $2,000 that is still payable.
- Interest is a "fee" that a creditor charges a debtor in exchange for a loan. Since interest payments, in the best case scenario, result in a creditor getting back all of the money given plus a percentage above that, they significantly encourage creditors to assume the financial risk of lending money; this creates a favorable return on investment (ROI).
- Interest Rate: The rate at which a portion of the principal, or the total amount owing on a loan, is paid back over a certain period of time with interest. The computation involves dividing the principal by the interest amount.
- Annual Percentage Rate (APR): The total cost of a loan, including origination, insurance, and/or interest, over a one-year period. See APR vs. APY and APR vs. Interest Rate as well.
- Pre-qualified: A financial institution's statement of pre-qualification for a loan is a non-binding, ballpark estimate of how much a person can borrow.
- Pre-approved: The initial stage of a formal loan application is pre-approval. Prior to pre-approval, the lender
- checks the borrower's income and credit score. Additional details regarding pre-qualification and pre-approval.
- Down payment: A sum of money paid up advance to a lender as part of the first loan repayment. The remaining expenses would be covered by the mortgage loan, which would be repaid over time with interest, if a 20% down payment of $42,600 were made in cash on a $213,000 home.
- Lien: A legal right a lender has on a property or asset in the event that the borrower defaults on loan payments; something used to secure loans, particularly mortgages.
- Private Mortgage Insurance (PMI): This type of insurance protects the borrower's ability to continue paying mortgage payments, and it is mandatory for some borrowers who use FHA loans or conventional loans with a down payment of less than 20%. Monthly mortgage insurance premiums are typically paid in conjunction with monthly mortgage payments, much like property taxes and homeowner's insurance.
- Prepayment: Making a partial or whole loan payment ahead of schedule. Because they miss out on interest charges they could have made had the borrower retained the loan for a longer period of time, some lenders actively penalize borrowers with an interest fee for early repayment.
- Foreclosure: The legal procedure and right that a lender employs to recover losses suffered when a borrower defaults on a loan; the proceeds of the public auction of the collateral asset are often used to pay off the mortgage obligation. See also Short Sale vs. Foreclosure.
Types of Loans
Open-End vs. Closed-End Loans
Two primary types of loan credit exist. The term "revolving credit" or "open-end credit" refers to credit that is available for multiple borrowing. The borrowing is "open" for further use. The most popular type of open-end credit is a credit card; if a person has a $5,000 credit limit, she can keep borrowing from that line of credit as long as she pays it off each month and never reaches or surpasses the limit, at which point she will no longer have any money left over. She maintains her $5,000 credit each time she pays the card down to zero dollars.
A type of closed-end credit is a term loan, which is a set sum of money that is lent in full with the understanding that it would be paid back in full at a later time. If someone has paid back $70,000 of a $150,000 closed-end mortgage loan, it does not imply that he has another $70,000 to borrow from; rather, it indicates that he is halfway through repaying the entire loan amount that he has already received and utilized. He will have to apply for a new loan if additional credit is required.
Secured vs. Unsecured
There are two types of loans: secured and unsecured. Since unsecured loans are not secured by assets, lenders are unable to place a lien on an asset to recover losses in the event that a debtor defaults. Instead, unsecured loan applications are accepted or denied based on the borrower's credit score, income, and credit history. Unsecured credit is typically less in quantity and has a higher annual percentage rate (APR) than secured loans because of the comparatively significant risk a lender assumes when granting a borrower an unsecured line of credit. Unsecured loans include personal loans, bank overdrafts, and credit cards.
Mortgages and auto loans are examples of secured loans, sometimes referred to as collateral loans, that are linked to assets. A borrower pledges an asset as security for these loans in return for money. Secured loans are comparatively safer investments for lenders, even if they typically give borrowers bigger sums of money at lower interest rates. If a debtor defaults on their loan, lenders may be entitled to take complete or partial possession of an asset, depending on the terms of the loan arrangement.
Other Types of Loans
Loans for U.S. Veterans (closed-end, government-secured), mortgages (closed-end, secured), consolidated loans (closed-end, secured), student loans (closed-end, frequently secured by the government), small business loans (closed-end, secured or unsecured), and even payday loans (closed-end, unsecured) fall under the broad categories of open-end/closed-end and secured/unsecured. Payday loans should be avoided in relation to the latter since their fine print nearly always indicates a very high annual percentage rate (APR), which makes loan repayment challenging, if not impossible.
Types of Mortgages
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Fixed-Rate Mortgages
Fixed-rate mortgages make up the great bulk of home loans. These are sizable loans that need to be paid back over an extended period of time, ideally within 10 to 50 years. They have a fixed interest rate that can only be altered by refinancing the loan; payments are made in equal monthly installments for the duration of the loan; and a borrower can make extra payments to speed up loan repayment. Loan repayment in these programs is split between principle reduction and interest payments.
The Federal Housing Administration (FHA) of the United States insures mortgage loans lent to high-risk borrowers by FHA-approved lenders. The government will insure a loan up to a certain amount, but these are not government loans; rather, they are the insurance of a loan issued by an independent entity, like a bank. Federal Housing Administration (FHA) loans are typically granted to first-time homebuyers with low to moderate incomes, no 20% down payment, and a poor credit history or bankruptcy history. Notably, FHA loans allow people to buy a home without putting down 20% of their income, but they also require these high-risk applicants to obtain private mortgage insurance.
See also: Conventional Loan vs FHA Loan.
VA Loans for Veterans
Home mortgage loans taken out by veterans of the armed forces are guaranteed by the U.S. Department of Veterans Affairs. VA loans are comparable to FHA loans in that the government insures or guarantees a loan provided by another lender rather than making the loan itself. The government reimburses the lender at least a quarter of the loan if a veteran defaults on it.
One of the unique advantages of a VA loan is that veterans are exempt from paying a down payment and from having to carry private mortgage insurance (PMI). Some veterans are considered high-risk borrowers and would be denied traditional mortgage loans since their tours of duty have occasionally impacted their civilian work experience and income.
One of the unique advantages of a VA loan is that veterans are exempt from paying a down payment and from having to carry private mortgage insurance (PMI). Some veterans are considered high-risk borrowers and would be denied traditional mortgage loans since their tours of duty have occasionally impacted their civilian work experience and income.
Other Types of Mortgages
There are also different types of mortgages, such as reverse mortgages, adjustable-rate mortgages (ARM), and interest-only mortgages. Fixed-rate mortgages continue to be the most prevalent mortgage type, with 30-year fixed-rate plans being the most widely used variety.
Deed of Trust
Mortgages are rarely, if ever, used in certain U.S. states. Instead, trust deeds, in which a trustee serves as a sort of middleman between lenders and borrowers, are used. See Deed Of Trust versus Mortgage for additional information on the distinctions between mortgages and deeds of trust.
See also: Deed Of Trust vs Mortgage.
Loan vs. Mortgage Agreements
Agreements for loans and mortgages are structured identically, however specifics differ based on the loan type and terms. Most agreements spell out exactly who the borrower and lender are, the interest rate (APR), the amount and timing of payments, and what happens if the borrower doesn't pay back the loan by the schedule. A loan may be receivable on demand (a demand loan), in equal monthly payments (an installment loan), or it may be good until further notice or due at maturity (a time loan), according to the book How to Start Your Business With or Without Money. Loans are exempt from most federal securities laws.
Loan agreements can be divided into two primary categories: bilateral and syndicated. The borrower and the lender enter into bilateral loan agreements, which are made between two parties (or three in deed of trust situations). Working with these loan agreements is rather simple, and they are the most prevalent kind. In order for a corporation to obtain a very big loan, syndicated loan arrangements are typically employed, which involve a borrower and several lenders, including banks. To reduce individual risk, several lenders combine their funds to produce the loan.
How Loans and Mortgages Are Taxed
Loans are a type of debt rather than taxable income, therefore borrowers do not pay taxes on the money they receive from a loan and do not deduct loan payments. Payments from borrowers are also not regarded as gross income, and lenders are not permitted to deduct the amount of a loan from their taxes. But when it comes to interest, lenders are required to count interest as part of their gross income, and borrowers can write off the interest against their taxes.
When a loan debt is cancelled prior to repayment, the regulations slightly alter. The borrower is now regarded by the IRS as having income from the loan. See Cancellation of Debt (COD) Income for further details.
The cost of private mortgage insurance (PMI) can currently be written off against taxes for those who have it. There is presently no indication that Congress will extend the deduction, and the rule is scheduled to expire in 2014.
The cost of private mortgage insurance (PMI) can currently be written off against taxes for those who have it. There is presently no indication that Congress will extend the deduction, and the rule is scheduled to expire in 2014.
Predatory Lending
Predatory lending practices should be known to those looking to borrow money. Lenders engage in these dangerous, dishonest, and occasionally even fraudulent activities that could endanger borrowers. The subprime mortgage crisis of 2008 was largely caused by mortgage fraud.
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