Money is required at every stage, be it a stage of an individual’s life or a stage of a business. At first individuals and commercial entities generally attempt to raise funds from their internal sources which mostly comprise of their own earnings or revenues. In case this does not suffice, they turn to external sources for raising funds. One such external source is debt. Debt involves borrowing money from a third party for a specified term at a specified rate of interest.
There are various sources of debt available today – from traditional moneylenders to institutional lenders to even the general public. Individuals and entities can choose one or multiple sources of debt as per their suitability and eligibility. This article looks at meanings of and differences between two forms of debt – loan and mortgage.
Definitions and meanings
A loan is a financial arrangement that involves borrowing of money by a borrowing entity from a lending entity. A loan is accompanied by an obligation on the part of the borrower to repay to the lender, the loan amount as well as compensation in the form of interest as per predetermined terms. Loans are taken with the purpose of meeting certain monetary requirements of the borrower and can be of various types including business loans, personal loans, home loans and vehicles loans etc.
A loan involves two parties – the lender and the borrower. The lender is an individual or institution who provides money to the borrower. Examples include, banks and financial institutions that provide credit and public investors that subscribe to bonds issued by commercial entities etc. The lender is entitled to receive back both the principal as well as a compensation at an agreed interest rate.
The borrower, on the other hand, is an individual or entity that avails the loan and receives the money from the lender. The examples of borrower include any entities or individuals that are in need of as well as eligible to receive funds under a loan arrangement. The borrower is obligated to make both repayment of principal amount as well as payment of any interest thereon to the lender, as per the terms specified by the loan agreement.
A loan is taken under a loan agreement that specifies the terms agreed between the lender and the borrower. It generally specifies the following:
- Interest rate: the compensation rate that the borrower will pay to the lender. The agreement also specifies whether the interest rate will be simple or compound and the periodicity at which it will to be paid.
- Repayment schedule: the manner in which and the timelines within which the loan (both principal sum and interest thereon) is supposed to be repaid.
- Security: the details of any collateral that the borrower may need to provide as a guarantee for repayment of the loan.
A mortgage is a type of secured loan in which the lender lends money, against a property of the borrower which is provided as a security. The property mortgaged against debt can be an unconstructed piece of land or a constructed residential or commercial property etc.
In the case of a mortgage, the physical possession of the property is not given to the lender but its title documents are usually submitted to and kept in the custody of the lender. This restricts the borrower from selling the property or remortgaging it whilst the loan is outstanding.
The title documents of the mortgaged property are returned to the borrower when the loan is repaid in full i.e., both the principal sum and the interest thereon is repaid. As mortgage loans involve the collateral of a property, they are usually opted for in cases where the borrower requires a high value loan or a loan of a relatively long tenure.
Difference between loan and mortgage
The eleven key points of difference between loan and mortgage have been listed below:
- A loan is the arrangement whereby a lender provides money to the borrower in lieu of payment of interest as compensation.
- A mortgage is a type of secured loan, wherein the lender provides a loan and in exchange has a lien on a property of the borrower that has been provided as a security for the loan.
2. Nature of security
- A loan can either be secured or unsecured. A secured loan is backed up by collateral of any tangible or intangible asset of the borrower whereas an unsecured loan has no such attached collateral.
- A loan qualifies as a mortgage only if it has a property (land, residential or commercial etc.) as an attached security.
3. Value and term of loan taken
- Regular loans or loans without high value security are usually available in case of relatively low value loans or loans of short tenure. The value of loan is determined after assessing credit worthiness of the borrower.
- Mortgages are generally taken for high value and long tenure loans which warrant a collateral in the form of the mortgaged property.
4. Interest rate applied
- For regular loans, interest rates are applied as per the nature of loan. For example, home loans and car loans are available at lower rate than say personal loans or student loans.
- Mortgage loans being secured can be generally availed at lower interest rate than regular unsecured loans.
- The scope of loans is wider as it includes all types of loans.
- A mortgage is a sub-set of secured loans and thus has a much narrower scope than loans in general.
6. Assessment for eligibility and amount of loan
- In the case of regular loans, the assessment of the credit worthiness and financial standing of the borrower is done to determine his eligibility for a loan.
- In case of a mortgage, in addition to the above, the lender also assesses the market value of the property to determine the amount of loan that can be sanctioned against such mortgaged property.
7. Lender – source of financing
- Loans can be availed from various different sources including the general public by way of public deposits or bonds.
- Mortgage loan offering is limited to certain entities such as banks or financial institutions.
8. Borrower – beneficiary of the loan
- Any entity that can demonstrate its ability to repay a loan can generally become a loan beneficiary.
- For an individual or entity to be eligible for a mortgage loan, it must own an unencumbered property.
9. Action in case of default
- The recovery action that a lender can take in case of a loan is guided by the terms of the loan agreement.
- In the case of a mortgage, the lender can auction off the mortgaged property for the recovery of defaulted loan amount as well as any accumulated interest thereon.
10. Risk for lender
- The risk for lender is higher in case of loans that have no or low value security attached as collateral.
- The risk for a lender is lower in case of a mortgage loan wherein the property kept as security is of commensurate amount as the loan.
11. Risk for borrower
- The risk for a borrower is lower in case of loans with no security attached because the recovery action is restricted to the agreed loan terms.
- The risk for a borrower is generally higher in case of a mortgage loan because the mortgaged property is entirely at risk for being attached by the lender in case of default.
Loan and mortgage both are means of fulfilling the funding needs of a borrower. Regular unsecured loans are suitable for both borrowers and lenders in case of routine low-value and high interest rate loans. On the other hand, mortgage loans make more sense when the borrower needs a higher amount of funds or when a lender requires a high value security considering the amount and nature of loan to be granted. In both cases, the key factor to determine the eligibility of a borrower (in addition to assessment of security, if any) is his assessed financial position and credit history.