What a person does with their money is their business, right? Not always. Lenders are indeed interested in how borrowers plan to use the funds they’re loaned — in fact, the reason for a loan is one of the application questions.
But does loan purpose really matter? Keep reading to find out.
What Is the Purpose of a Loan?
At its most basic, the purpose of a loan is the reason the applicant wants to borrow money. Even though there are many acceptable uses of personal loan funds, the loan application will likely include a section asking why the applicant is requesting the loan.
Why Does the Purpose of a Loan Matter?
Banks consider a number of factors in addition to the reason for the loan, such as the amount asked for and the applicant’s credit and employment history, among others. The purpose of including such information on a loan application is so that a bank can assess the potential risk of lending money to an individual.
But the borrower’s reason for needing a loan can be a factor, too, because how much money is needed and how the debt can be repaid — both of which might be influenced by the underlying need — might make some types of loans a better fit than others.
Recommended: What Are the Common Uses for Personal Loans?
Are There Different Guidelines Based on the Purpose of a Loan?
Lenders may request certain pieces of information based on the type of loan being applied for.
For instance, a home loan application may include a section asking if the purpose of the loan is for a purchase, refinance, initial construction, or home improvement. Additional questions may be required based on what the answer to that question was. If the home loan is for the purpose of refinancing, the lender may want to know the original purchase date and cost of the home, if there are any other loans using the home as collateral, any other improvements made to the home and their costs, and what the purpose of the refinance is.
Does the Purpose of a Loan Influence Interest Rates?
The interest rate a lender charges for a loan can be dependent on the purpose of the loan, depending on the lender. Some lenders may set interest rates determined solely by the loan amount, the loan term, and the creditworthiness of the applicant. Other lenders might use those factors, plus have interest rate ranges for different loan purposes. For instance, a lender might charge as much as 18% for a debt consolidation loan, but only 6.5% for a used auto loan, on loans for the same amount and term.
Each lender sets its own rates for loans. They may use the rates set by the Federal Reserve as a base to work from, but also take into account their competitors’ interest rates. Lenders are in the business of making a profit, so they will price their loans to maximize that while still being able to attract customers.
Common Reasons for Getting a Loan
Most people have something particular in mind when they decide to borrow money.
But although every person sees themselves and their individual needs as unique, it turns out the reasons for taking out a personal loan tend to fall into some fairly common buckets:
Debt Consolidation:
Total household debt in the U.S. surged to $15.58 trillion by the end of 2021 — $1.4 trillion higher than two years previous, according to data from the Federal Reserve Bank of New York. But that number consists of a variety of types of debt, including credit card balances, student loans, mortgages, and other lending products. For 37% of Americans, the reason for a personal loan is to consolidate multiple debts, Finder.com found.
Medical Bills:
It may not be surprising in this pandemic era that medical expenses are one of the more common uses of personal loan funds. About 26% of personal loans are taken out to pay for medical expenses not covered by health insurance.
Recommended: How To Pay for Medical Bills You Can’t Afford
Home Improvements:
The pandemic saw an uptick in personal loan funds used for home improvement expenses, according to a 2021 Ipsos survey , with 25% of survey respondents saying they used their personal loan funds this way. With people staying home to avoid contracting Covid-19, they may have begun to notice all the home maintenance tasks they had been putting off, and had the time to tackle them.
Something Else:
The Finder.com survey found that other reasons for taking out a personal loan might be helping a family member, funding a move, or paying for a wedding or funeral.
Planned vs Unexpected Expenses:
Whether it’s a wedding, education, or a home renovation, there are some expenses that can be expected and planned for accordingly. Others, such as an emergency medical bill or unexpected car repairs, require a sudden inflow of cash — sometimes quickly.
What to Consider:
Having longer lead time before borrowing money can give an individual more time to compare loan offerings and typical requirements for getting approved, helping them to find more favorable rates and terms.
For example, secured loans may have lower interest rates than unsecured loans because the loan is secured with collateral, potentially lowering the risk to the lender.
But the process of obtaining such a secured loan can also be slower due to the time it takes to make sure the collateral being used is of sufficient value. As such, an unsecured personal loan may be the quickest way to obtain funds to cover unexpected expenses, although it may cost more overall.
Smaller vs Larger Expenses:
In 2020, the average personal loan balance in the U.S. was $16,458, according to Experian. But that number only tells part of the story. About 40% of Americans don’t have sufficient cash on hand to cover an unexpected $400 expense, a study by the Federal Reserve found — a finding that highlights that depending on the reason for a loan, a person may need to only borrow a little or a lot.
What to Consider:
Calculating the amount needed before applying for a loan and seeking out a loan that’s the right fit is a good idea.
An alternative way to access the funds — such as charging it to a credit card or dipping into savings — may be a more favorable option than a personal loan, after factoring in potential costs such as origination fees charged by some lenders.
One-time vs Ongoing Expenses:
Will the loan funds be used to cover a defined, one-time fee, or will the expenses be ongoing? Depending on the loan purpose, a personal loan might not be the right fit.
What to Consider:
Funds from a personal loan are disbursed in one lump sum, and interest is paid on that sum according to a fixed repayment schedule.
If the loan purpose is an expense that is ongoing or variable, such as wedding or home improvement costs, a line of credit might make sense financially, since interest is only charged on the amount drawn at any one time, and money borrowed can be repaid on a more flexible basis.
Lines of credit tend to come with variable instead of fixed interest rates, however, so the overall amount due may be hard to predict.
Loans To Pay Off Other Loans:
Using one debt to pay off another can sometimes be a sound financial strategy. But when debt consolidation or refinancing is the loan purpose, not just any personal loan will do.
What to Consider:
Debt consolidation and loan refinancing requires some number crunching to ensure the new loan is more favorable than the debt it’s replacing, factoring in any fees or penalties attached to the original loan(s).
Personal Loan Approval
The length of time from application to personal loan approval can vary by lender. On average, approval can take up to three business days for an online lender and up to seven business days for a bank or credit union. Some online lenders, though, offer same-day approval.
Some things that can make this a quicker process are making sure your credit report is free of errors and having required documents ready when the lender requests them. Loan applications that don’t have unusual circumstances, e.g., self-employment income verification or a high debt-to-income ratio, are more likely to be approved faster than those that do.
Once a personal loan application has been approved by the lender, the funds may be made available to the borrower in just a few days or up to a week, depending on the type of lender. Some online lenders may disburse funds the same day as approval.
Recommended: How to Get Approved for a Personal Loan
The Takeaway
There are, indeed, different types of loans for different purposes. Applicants may have their own reasons for wanting a loan, but lenders will want to know what the funds will be used for. There may be certain loans better suited to certain funding needs than others, and a lender will likely want to make sure the loan suits the purpose.
With no fees required and competitive interest rates, SoFi offers unsecured personal loans for a variety of purposes, such as consolidating high-interest credit card balances or springing for a big purchase.
FAQ
Why is it important to know the purpose of a loan?
Lenders may want to know the purpose of a loan so they can assess the risk of lending. Borrowers will want to apply for the right type of loan for the purpose.
What are examples of the purpose of a loan?
There are many reasons people may want to use a personal loan, including debt consolidation, medical expenses, home improvements, or others.
What happens if I use my loan for a different purpose?
Some loans are meant to be used for a certain purpose, such as auto loans or mortgages. Personal loans, however, can be used for many purposes, and a lender may not check to see if the funds are being used as intended on the loan application. But it’s a good idea to review the loan application to understand any restrictions on the use of the funds.
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