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.
Common Reasons for Getting a Loan
Most people have something particular in mind when they decide to borrow money. According to a pre-pandemic 2019 survey from Experia, about three out of every four people who are considering taking out a personal loan say the decision is motivated by a specific upcoming need or life event.
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:
1. Large purchases
Whether a new car, a computer or other big-ticket items, being able to cover a large purchase is the most commonly cited reason for a loan. Among those who had already taken out a personal loan, 28% said they did so to pay for a large purchase.
2. Debt consolidation
Total household debt in the US surged to $14.56 trillion during the pandemic, according to data from the Federal Reserve Bank of New York, including credit card balances, student loans, mortgages, and other lending products. For 26% of Americans, the reason for a loan is to consolidate multiple debts, Experian found.
3. Home improvements
Whether it’s a full renovation, a nice-to-have upgrade such as new floors or paint, or something more critical such as new plumbing or a roof, 17% of Americans put their personal loan funds towards home improvements.
4. Loan refinancing
Similar to debt consolidation, loan refinancing can help make it easier for an individual to pay back what they owe—in this case via a more favorable interest rate or loan repayment terms than those attached to the original loan. Nearly one in 10 personal loans are used to refinance other existing loans, Experian found.
5. Something else
Nearly one-third of respondents to the Experian survey said they plan to take out a loan for another purpose that wasn’t listed.
As one might expect, the pandemic has shifted some elements of how people handle personal finances. According to a survey from Ipsos for Forbes Advisor, the most common reasons for taking out a personal loan during the pandemic were:
- Medical bills (21%)
- Debt consolidation (20%)
- Financing a vehicle (20%)
- Auto repairs (20%)
Why Loan Purpose Matters
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.
The loan purpose might also inform the ultimate decision whether to borrow money at all, after calculating the costs. Some reasons for taking out a loan—such as to pay for improvements that increase the value of a home or education that can boost earning power—can provide benefits that, over time, may even outweigh the cost of borrowing.
Basically, the more time spent considering the specific reasons for applying for a loan, the better equipped someone will be to find the best loan for their needs and financial situation.
Planned vs. Unexpected Expenses
Whether it’s a wedding, education or a home renovation, there are some expenses that can be seen and planned accordingly. Others, such as an emergency medical bill or unexpected car repairs, require a sudden inflow of cash—sometimes quickly.
What to consider:
Having a 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 balance drawn, 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).
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.
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