A loan is an amount of money you borrow from a financial institution, such as a bank, credit union or online lender, that must be repaid, with interest, by an agreed-upon date.
There are different types of loans designed for different uses. Loans can be secured by collateral or unsecured, can have fixed or variable interest rates, and can have a variety of term lengths.
How loans work
A bank or other lender’s decision to let you borrow money is based in part on your creditworthiness — a measure of your ability and likelihood to pay back the loan in a timely fashion. To determine creditworthiness, a financial institution considers various factors, like your income, assets, credit score, credit history and current debt load.
Loans are made at a certain rate of interest, which is also based on factors such as your credit score and the type of loan you want. As the borrower, you agree to pay back the principal amount and interest by a set time or on a set schedule, in addition to the predetermined rate of interest.
Loans vs. lines of credit
Both loans and lines of credit are methods of borrowing money, but the way in which funds are provided and paid back differs.
With a loan, you usually receive a lump sum of money at a fixed or variable interest rate. You pay back the amount over time in regular payments (called installments) or repay the entire debt at a set time — along with interest on the entire amount. Loans are handy for one-time purchases or large expenses.
In contrast, a line of credit works like a credit card; it offers a pool of money up to a predefined limit from which you can take out as much or as little money as you need at a time. You can also pay back and withdraw from the account repeatedly. Though your interest rate is variable, you’ll only pay interest on the funds you withdraw from the account rather than the entire amount available to you. This flexibility means a line of credit can be ideal for people who want access to funds repeatedly over a period of time.
Secured vs. unsecured loans
Secured loans require collateral (such as a house or car) as a guarantee to the lender in the event that you default on the loan. These loans sometimes take longer to approve because the bank needs to confirm the value of your assets in addition to your creditworthiness. You risk losing the asset you pledge as collateral if you can’t repay the loan. However, secured loans also typically come with lower interest rates because the lender is protected by your collateral. In case you stop payments, the lender can take the asset from you..
An unsecured loan is not backed by collateral. It may be faster to get approved for an unsecured loan. Because the lender takes on more risk, you’ll typically pay higher interest rates than on a secured loan. But you don’t risk losing a major asset like a home.
Common types of loans in Canada
A personal loan is a lump sum of money borrowed from a financial institution. You repay the debt in weekly or monthly payments over a period that usually ranges from six to 60 months. The funds have a fixed or variable rate of interest.
In Canada, most personal loans are unsecured, meaning you don’t need to provide collateral. However, secured personal loans generally have lower interest rates, so you may want to ask your lender about both types of loans so you can compare your options.
There are few restrictions on how you can use a personal loan. The amounts range from as little as $100 to as much as $50,000, and some lenders may even have minimum loan amount requirements.
Known more commonly as mortgages, home loans are offered by financial institutions or direct lenders, and secured by real estate. Home loans may have fixed or variable rates of interest. Mortgage lending is governed by strict rules (for example, mortgage insurance and a financial stress test) and can feature high penalties.
Unlike a personal loan, which can be used for a variety of purposes, mortgages are only used to buy real estate. Home loans are usually for large amounts that you pay back over long periods of time, such as 25 or 30 years, plus interest. Your property acts as collateral, so if you default on payments, your lender can take possession of the home and sell it.
Home repair and renovation loans
In Canada, unsecured personal loans are a common way to pay for home repairs and renovations. If you have a good credit score, you might also have the option of applying for a personal line of credit, which could offer better interest rates.
For those who have sufficient home equity there are additional home improvement financing options. You could refinance your mortgage for more than the outstanding balance and use the extra funds to pay for renovations. Using your home as collateral, you could also apply for a home equity line of credit (HELOC), and then only withdraw money as needed. Typically, HELOCs come with low interest rates because they are secured by collateral.
The cost of post-secondary education is high, and many students must borrow money to cover the cost. In Canada, the most common student loans are issued by the federal or provincial governments. Each loan has different requirements and repayment terms. You also have the option of applying for a personal student loan or a student line of credit from banks or online lenders.
A car loan is a way to buy a new or used car without having the full price in cash. Car loans are available from many financial institutions and sometimes directly from the dealership as well. The car dealer may have in-house financing or may apply for a loan on your behalf after you select the vehicle you want. Again, it’s a good idea to shop around and collect several quotes from different lenders to make sure you find the best terms and interest rate.
A business loan is typically offered by financial institutions to a company or an entrepreneur for launching or making improvements to their businesses. The funds can be used for business-related expenses like buying new supplies, upgrading technology or expanding operations.
If you don’t have the funds to max out your registered retirement savings plan in a particular year, you can get an RRSP loan and use those funds to make up the annual contribution to your account. Often, you don’t have to start making payments on the loan for the first 90 days, which may allow you to use your tax refund to repay part or all of the loan.
An RRSP loan is helpful only if the tax refund you’ll get or the interest you’ll earn in your RRSP investment account will exceed the interest you’ll pay on the loan. If you’re not sure whether an RRSP loan is a good choice, a financial advisor can help you crunch the numbers.