Financial and Legal Definitions
Financially, loans are structured between individuals, groups, and/or firms when one person or entity gives money to another with the expectation of having it repaid, usually with interest, within a certain amount of time. For example, banks frequently loan money to people with good credit who are looking to purchase a car or home, or start a business, and borrowers repay this money over a set amount of time. Borrowing and lending happen in a variety of other ways, too. It is possible for individuals to lend small portions of money to numerous others through peer-to-peer lending exchange services like Lending Club, and it is common for one person to loan another money for small purchases.
How a loan is treated legally varies according to the type of loan, such as a mortgage, and the terms found in a loan agreement. These contracts are judged and enforceable according to the Uniform Commercial Code and contain information about the loan’s terms, repayment requirements, and interest rates; they also include details on the repercussions for missed payments and default. Federal laws are set out to protect both creditors and debtors from financial harm.
Though people frequently borrow and lend on smaller scales with no contract or promissory note, it is always advisable to have a written loan agreement, as financial disputes can be settled more easily and fairly with a written contract than with an oral contract.
Loan and Mortgage Terminology
Several terms are commonly used when discussing loans and mortgages. It is important to understand them before borrowing or lending.
- Principal : The amount borrowed that has yet to be repaid, minus any interest. For example, if someone has taken out a $5,000 loan and paid back $3,000, the principal is $2,000. It does not take into account any interest that might be due on top of the remaining $2,000 owed.
- Interest: A “fee” charged by a creditor for a debtor to borrow money. Interest payments greatly incentivize creditors to take on the financial risk of lending money, as the ideal scenario results in a creditor earning back all the money loaned, plus some percentage above that; this makes for a good return on investment (ROI).
- Interest Rate : The rate at which a percentage of the principal — the amount of a loan yet owed — is repaid, with interest, within a certain period of time. It is calculated by dividing the principal by the amount of interest.
- Pre-qualified : Pre-qualification for a loan is a statement from a financial institution that provides a non-binding and approximate estimate of the amount a person is eligible to borrow.
- Down Payment : Cash a borrower gives to a lender upfront as part of an initial loan repayment. A 20% down payment on a home that is valued at $213,000 would be $42,600 in cash; the mortgage loan would cover the remaining costs and be paid back, with interest, over time.
- Lien : Something used to secure loans, especially mortgages; the legal right a lender has to a property or asset, should the borrower default on loan repayments.
- Private Mortgage Insurance (PMI) : Some borrowers—those who use either an FHA loan, or a conventional loan with a downpayment of less than 20%—are required to purchase mortgage insurance, which protects the borrowers ability to keep making mortgage payments. Premiums for mortgage insurance are paid monthly and usually bundled with the monthly mortgage payments, just like homeowner’s insurance and property taxes.
- Prepayment : Paying a loan in part or in full before its due date. Some lenders actually penalize borrowers with an interest fee for early repayment as it causes lenders to lose out on interest charges they might have been able to make had the borrower kept the loan for a longer time.
- Foreclosure: The legal right and process a lender uses to recoup financial losses incurred from having a borrower fail to repay a loan; usually results in a public auction of the asset that was used for collateral, with proceeds going toward the mortgage debt. See also Foreclosure vs Short Sale.
Types of Loans
Open-End vs. Closed-End Loans
There are two main categories of loan credit. Open-end credit — sometimes known as “revolving credit” — is credit that can be borrowed from more than once. It’s “open” for continued borrowing. The most common form of open-end credit is a credit card; someone with a $5,000 limit on a credit card can continue to borrow from that line of credit indefinitely, provided she pays off the card monthly and thus never meets or exceeds the card’s limit, at which point there is no more money for her to borrow. Each time she pays the card down to $0, she again has $5,000 of credit.
When a fixed amount of money is lent in full with the agreement that it be repaid in full at a later date, this is a form of closed-end credit; it is also known as a term loan. If a person with a closed-end mortgage loan of $150,000 has paid back $70,000 to the lender, it does not mean that he has another $70,000 out of $150,000 to borrow from; it simply means he is a portion of the way through his repayment of the full loan amount he already received and used. If more credit is needed, he will have to apply for a new loan.
Secured vs. Unsecured
Loans can either be secured or unsecured. Unsecured loans are not attached to assets, meaning lenders cannot put a lien on an asset to recoup financial losses in the event that a debtor defaults on a loan. Applications for unsecured loans are instead approved or rejected according to a borrower’s income, credit history, and credit score. Due to the relatively high risk a lender takes on to give a borrower an unsecured line of credit, unsecured credit is often of a smaller amount and has a higher APR than a secured loan does. Credit cards, bank overdrafts, and personal loans are all types of unsecured loans.
Secured loans — sometimes known as collateral loans — are connected to assets and include mortgages and auto loans. In these loans, a borrower places an asset up as collateral in exchange for cash. Though secured loans usually offer larger amounts of money to borrowers, at lower rates of interest, they are relatively safer investments for lenders. Depending on the nature of the loan agreement, lenders may be able to seize partial or full control of an asset if a debtor defaults on his or her loan.
Other Types of Loans
Open-end/closed-end and secured/unsecured are broad categories that apply to a wide variety of specific loans, including student loans (closed-end, often secured by the government), small business loans (closed-end, secured or unsecured), loans for U.S. veterans (closed-end, secured by the government), mortgages (closed-end, secured), consolidated loans (closed-end, secured), and even payday loans (closed-end, unsecured). With regard to the latter, payday loans should be avoided, as their fine print almost always reveals a very high APR which makes the loan repayment difficult, if not impossible.
Types of Mortgages
The vast majority of home loans are fixed-rate mortgages. These are large loans that must be repaid over a long period of time — 10 to 50 years — or sooner, if possible. They have a set, or fixed, rate of interest that can only be changed by refinancing the loan; payments are of equal monthly amounts across the lifetime of the loan, and a borrower can pay additional amounts to pay off his or her loan more quickly. In these loan programs, loan repayment first goes toward paying interest, then to paying down the principal.
See also Adjustable Rate Mortgage vs Fixed Rate Mortgage.
FHA Mortgage Loans
The U.S. Federal Housing Administration (FHA) insures mortgage loans that FHA-approved lenders give to high-risk borrowers. These are not loans from the government, but the insurance of a loan made by an independent institution, such as a bank; there is a limit on how much the government will insure a loan. FHA loans are usually given to first-time homebuyers who are low- to moderate-income and/or are not making a 20% down payment, as well as to those with a poor credit history or a history of bankruptcy. It is worth noting that though FHA loans enable those who don’t make a 20% down payment to purchase a home, they do require these high-risk borrowers to take out private mortgage insurance.
See also Conventional Loan vs FHA Loan.
VA Loans for Veterans
The U.S. Department of Veterans Affairs guarantees the home mortgage loans taken out by military veterans. VA loans are similar to FHA loans, in that the government is not lending money itself, but rather insuring or guaranteeing a loan supplied by another lender. In the event that a veteran defaults on his or her loan, the government repays the lender at least 25% of the loan.
A VA loan comes with some specific benefits, namely that veterans are not required to make a down payment or to carry private mortgage insurance (PMI). Due to tours of duty having sometimes affected their civilian work experience and income, some veterans would be high-risk borrowers who would be rejected for conventional mortgage loans.
Other Types of Mortgages
There are many other kinds of mortgages, including interest-only mortgages, adjustable-rate mortgages (ARM), and reverse mortgages, among others. Fixed-rate mortgages remain the most common type of mortgage, by far, with 30-year fixed-rate programs being the most popular form of them.
Deed of Trust
Some U.S. states do not use mortgages very often, if at all, and instead use a trust deed system, wherein a third party, known as a trustee, acts as a sort of mediator between lenders and borrowers. To learn more about the differences between mortgages and deeds of trust, see Deed Of Trust vs Mortgage.
Loan vs. Mortgage Agreements
Loan and mortgage loan agreements are laid out similarly, but details vary considerably depending on the type of loan and its terms. Most agreements clearly define who the lender(s) and borrower is, what the interest rate or APR is, how much must be paid and when, and what happens if the borrower fails to repay the loan in the agreed upon time. According to the book How to Start Your Business With or Without Money , “A loan may be payable on demand (a demand loan), in equal monthly installments (an installment loan), or it may be good until further notice or due at maturity (a time loan).” Most federal securities laws do not apply to loans.
There are two main types of loan agreements: bilateral loan agreements and syndicated loan agreements. Bilateral loan agreements take place between two parties (or three in the case of deed of trust situations), the borrower and the lender. These are the most common type of loan agreement, and they are relatively straightforward to work with. Syndicated loan agreements take place between a borrower and multiple lenders, such as multiple banks; this is the agreement commonly used for a corporation to take out a very large loan. Multiple lenders pool their money together to create the loan, thereby lowering individual risk.
How Loans and Mortgages Are Taxed
Loans are not taxable income, but rather a form of debt, and so borrowers pay no taxes on money received from a loan, and they do not deduct payment made toward the loan. Likewise, lenders are not allowed to deduct the amount of a loan from their taxes, and payments from a borrower are not considered gross income. When it comes to interest, however, borrowers are able to deduct the interest they have been charged from their taxes, and lenders must treat interest they have received as part of their gross income.
The rules change slightly when a loan debt is canceled before repayment. At this point, the IRS considers the borrower to have income from the loan. For more information, see Cancellation of Debt (COD) Income.
Currently those with private mortgage insurance (PMI) are able to deduct its cost from their taxes. This rule is set to expire in 2014, and there is currently no sign that Congress will renew the deduction.
Those seeking to take out a loan should be aware of predatory lending practices. These are risky, dishonest, and sometimes even fraudulent practices carried out by lenders that may harm borrowers. Mortgage fraud played a key role in the 2008 subprime mortgage crisis.