If you are embarking on the exciting adventure of buying a new home, then you’ve probably heard the terms “loan” and “mortgage” used interchangeably. While a mortgage is a type of loan, the two don’t necessarily work the same way. Let’s break down how mortgages and loans work.
What is a loan?
A loan is a financial agreement between two parties. The lender gives money to the borrower in exchange for repayment of the loan principal amount plus interest. The borrower agrees to take on the debt and repay it at the lender's terms.
There are different forms of loans, including term loans and revolving loans,. These loans can be for personal or commercial purposes and can be unsecured or secured. Each type has its own benefits and disadvantages and is used in different financing scenarios.
When you borrow money, you agree to pay it back with interest over time. With a term loan, generally, you need to pay it off over a specific period of time with fixed payments. With a revolving loan, you can withdraw money within a specified credit limit and can make additional withdrawals as you make repayments.
What is a mortgage?
A mortgage is a type of loan, but your home or property is tied to the terms of the loan. A mortgage is considered a secured loan because your home or property is being used as collateral and the mortgage will be registered on title to your home. This means that if you fail to meet repayment requirements, the lender will have legal rights to claim and sell your property. This process is called foreclosure.
A mortgage is used to purchase or refinance a new home or property and can also be used to access the equity in your current home for other purposes. Home purchases tend to be quite expensive, and most borrowers do not have all of the cash needed upfront for the purchase. Lenders determine whether to provide a mortgage through a financial background check, where they look at your credit score, income and your debt-to-income level among other factors. Lenders will also usually obtain an appraisal to determine the value of the property, because this will impact how much they can lend to you under the mortgage.
How do you use loans or mortgages?
A loan can be used for home purchases or other financial needs. Here are a few common loan types to give you an idea:
Secured loans are often used for larger purchases such as a vehicle. The vehicle is considered collateral for the loan.
Unsecured personal term loans can be used for a variety of purchases, including a bedroom remodel, wedding or debt repayment.
Revolving loans come in the form of credit cards and lines of credit. They can be used over and over as borrowers repay the debt placed on the card or withdrawn from the line of credit.
Student loans to help pay for your education have set repayment terms. Sometimes, when a student loan is backed by the government, borrowers can access special repayment assistance programs when in need.
Mortgages are used for home and property purchases and home refinances. Scotiabank offers the Scotia Total Equity Plan® (STEP). By leveraging equity in your home, STEP offers access to a broad range of borrowing products at lower interest rates to cater to your individual long-term and short-term financial plans.
What is collateral?
For some loans, collateral is required to get the loan. Collateral is the asset the lender is promised to secure the repayment of a loan. If the borrower fails to repay the loan, the lender can legally keep and sell the collateral.
For car loans, the vehicle is considered the collateral. If the borrower stops loan repayment, the vehicle could be repossessed. The lender can sell the vehicle, apply that total to your debt and collect from you any remaining balance.
For other loans, collateral can be cash. For example, individuals who have difficulty getting a credit card or loan can increase their credit with a secured credit card.
With a mortgage , your home or property is the collateral. If you as the borrower do not meet your financial obligations under the mortgage, the lender is able to take action to claim and sell the home.
What are the requirements?
Different loan types can have different borrower requirements. Typically, a lender will require the following:
Proof of income and employment. You will likely need to show your salary slips and/or an employment letter.
Debt-to-income ratio. This is calculated by dividing monthly debt by monthly gross income (the amount earned before anything is taken out).
Minimum credit score. Each lender sets its minimum credit score, but generally, any score over 700 is considered good.
Collateral for secured loans. If it is a vehicle loan, the collateral is the vehicle you are purchasing. However, if you are applying for a secured personal loan, lenders could accept paid-off cars, bank savings deposits, and investment accounts as collateral.
Credit cards usually have fewer requirements, which can include things like having a verifiable income, a physical address and the required minimum credit score set by the lender.
Mortgages are a type of loan that can require more documentation. If you are applying for a new mortgage loan or refinance, expect to provide the following information:
Proof of income and employment
A list of assets, including bank account totals, vehicles and investments
A list of debt and payment obligations
Information about the property to be used as collateral
How do I know whether to use a mortgage or a more general type of loan?
Loans and mortgages are two types of borrowing solutions that can help borrowers fund their dream purchases. What will work best for you will depend on your specific financial situation. By working with an advisor, you can find what borrowing path will work best for you as you built towards your financial goals.
