The common term used to describe this is the loan purpose. The lender would want to know the purpose of the loan so that they can set the interest rates based on the risk factor that accompanies your loan application.
The term is however not used for most of the loans. Only those conditional loans have this requirement.
For example; business loans and mortgages. For mortgages, the lender tries to establish the cost to income ratio. The ratio should not be higher than 28.
Home costs or expenses include the potentially applicable principal, the insurance cover, collections, etc. Therefore, when pricing, these risk-based factors are considered by the lenders in coming up with the mortgage price that balances and alleviates the risk factors which come into play.
For instance, when taking out a mortgage for consolidating credit card debts, then the risk factor goes up. So, the lender has to limit the number of funds loanable to you.
However, another way to increase your capacity is to view the value of the home. Substantial equity in the house may guarantee you more funds despite the constant risk factor.
Why do people take out financing?
As mentioned, the major lending product which attracts such scrutiny is the mortgage, business loans, and student loans.
You can take out a mortgage for purchasing a property, refurbishing a property or constructing a property.
There are two major types of mortgage: private and commercial mortgages.
For private mortgage, you can apply for funds to buy or construct a single dwelling unit or multi-dwelling family unit. This includes purchasing vacation homes, condos, etc.
On the other hand for commercial mortgages; it involves construction or purchase of investment property, either for business premises or residential letting property.
Another reason for taking a mortgage is to refinance debt. The outcomes may vary depending on your specifications.
For instance, people refinance for a varied amount of reasons including, getting a lower rate comfortable payment plan, intent to shorten or lengthen their payment period, refinance another mortgage which has higher rates, or for home repairs and general home refurbishment.
Whichever the reason or purpose you quote for the lender, you will be still in qualification parameters.
How loan purpose affects the rates of a mortgage?
Underwriters use a wide range of factors to determine the rates of interest to be charged on a mortgage. The loan purpose is just one of them.
The purpose of the loan is used by the underwriters to check the risk level of the borrower. This determinant is very crucial in calculating the amount to be borrowed from your point of standing.
Of course, other factors like a credit history would come in later. But this would be primarily used to determine the loan capacity which can be advanced to the borrower and be repaid in time and in full.
Low-risk caption on the client would help the confidence and motivation to obtain a home or a business premise.
Furthermore, you should note that the underwriting process by the lender is conducted differently for different loan purposes. This means each loan purpose is treated individually and depending on the use it may be riskier or less risky.
How loan purpose affects business loans?
A business loan just like a mortgage is meant specifically for the activities in and around businesses.
Business loans include; bank loans, invoice business financing, micro-business loans, cash advance loans, mezzanine financing, and cash flow financing.
A majority of these business loans are secured. Therefore, the lender is likely to ask for the loan purpose with which they use to determine the amount to give.
For example, since these loans are specific, you would expect that their securities are equally loan-specific. For the case of business invoice financing where the loan is taken against the unpaid accumulated customer invoices.
Hence, you cannot begin to apply for a cash flow financing to secure it with card purchases. Therefore, the loan purpose assists the lender to save time with long processes of underwriting.
Also, most business loans are financing forms that are required in a short time to help run a business. If the funds take long, then the normal business operation is likely to be hampered.
Also, it is good to note that business loans do not require a good credit record. Especially those businesses that have been established for long.
Hence, the lender’s fee is easily deducted from the amount in the deal and does not have to accrue in form of interest. This happens especially is the business needs working capital and trades, for example, credit card purchases for quick liquid cash.
Where the lender deducts their fees from the amount they give out in cash. However, if the business is a startup, the owner is required to have a good credit record as well as state the use of the financing for the lender to have a clear knowledge of the risk factor they are dealing with.
Student loans and loan purpose
A student loan is another form of strict financing from the lender where the product is supposed to strictly be used to support the learner for higher education in payment of school tuition fees, upkeep and other utilities that revolve around school.
The rates for student loans are generally low and have very favorable payment terms. Usually, these loans are provided and regulated by the government but their structure differs from one country to another.
The lender would ask for the purpose to set out these privileges in your loan.
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Loan purpose as discussed above is a term that is commonly used in the banking and lending industry in general. It gives the lender a notion of what you intend to use the potential financing is approved.
Your lender would then use this information differently based on the loan purpose you have cited to either set your rates of interest and loan capacity, set the fees on the deal or include specific privileges accorded to a specific loan.