Definition of a Loan
Generally, a loan is defined as a borrowed amount of money that is repaid in full as well as with a certain amount of interest.
This is a broad definition as it is well known that there are many types of loans. The sub-categories for loans include: open-ended, closed-ended, secured, unsecured, conventional, and payday loans.
Secured vs Unsecured
The most common types of loans are “secured” loans where there is some form of collateral (ie. a house, car, piece of real estate, etc.). This allows the lender to collect on amounts owed in the case that the borrower stops making payments. Loans like these may require that the borrower obtains some form of insurance on the loan to protect the lender’s interest. Mortgages fall under the category of secured loans.
Unsecured loans are based solely on the borrower’s credit worthiness. They also come with higher interest rates than a secured loan because of the additional risk, but may be a good option for those that would rather not rely on credit cards to make purchases (due to potentially higher fees), but do not qualify for a home equity line of credit (HELOC). Unsecured loans include most lines of credit provided by your financial institutions and may be revolving with a variable rate of interest or fixed in both its term and interest rate.
An unsecured loan may be used as a down payment towards a property. It is best to speak with a mortgage specialist to find out what may be the best method of making your down payment on your next purchase.
Open-ended vs closed-ended
In terms of loans, an open-ended loan is one that allows the borrower to take out amounts up to a certain limit (repeatedly) and allows for repayment without a prepayment penalty. The most common example of an open-ended loan is a line of credit or a “revolving” line of credit.
A closed-ended loan is one that HAS prepayment penalties. This is the fundamental difference. Closed-ended loans typically benefit the lender as this lowers the risk of prepayment (the risk that they will not receive (as much) interest on the amount they have loaned out) as well as the reinvestment risk (having to lend their money at lower rates) for the lender.
These types of loans typically range from $100 to $1500 and have a much higher interest rate than the loans mentioned above. As such, they are typically for short periods of time and are paid back typically on the borrower’s next payday. The intent of these loans is to cover expenses until the borrower receives their next pay cheque.
Should the loans not be paid back on time, the interest will continue to accumulate resulting in the borrower relying more on the payday loan service. Those that utilize this service may have low income and not be able to apply for more conventional forms of credit such as a credit card or a line of credit.
These types of loans are generally regarded as scams as they often advertise that they are no-fee loans and will have you pre-approved right away regardless of the purpose of the loan.They will then ask for administration fees, legal fees, etc. to be paid upfront before a loan amount is given out. When the money is paid to them, they will then take the money, leaving the would-be borrower worse off.
An article outlining the pitfalls of Advance-Fee Loans has been added to our Identity Theft, Scams and other forms of Trickery List.
In all cases lenders are generally concerned with the minimum payments the borrower is making on their loans. Why the minimum payments? If the borrower is currently overwhelmed with the number and/or size of the payments, the lender will be reluctant to lend funds due to the chances the borrower will be unable to service the loan they were given.
To learn more about loans and how they can impact a mortgage application, please contact us anytime!