What is a Non-Purpose Loan?
A non-purpose loan is a type of loan that involves complex structuring and uses investment securities as collateral. Borrowers do not need to liquidate their securities and can continue to receive the interest and dividend income from their securities.
- A non-purpose loan is an unconventional loan that involves using investment securities as collateral; multiple investment accounts can be used to obtain the loan.
- Borrowers continue to benefit from interest, dividends, and capital appreciation received from their investment portfolio.
- Proceeds from non-purpose loans cannot be used to invest in or trade securities.
- The portfolio of the borrower may be liquidated if the market value of the securities backing the loan falls significantly.
How Does a Non-Purpose Loan Work?
Financial institutions and brokerages offer non-purpose loans with required regulatory documents. Borrowers seeking such a loan must also fill a compliance document that highlights the terms and obligations of the non-purpose loan. Under Regulation U, financial institutions must disclose whether a loan is a non-purpose loan to the Federal Reserve. These disclosure requirements can differ by region.
Non-purpose loans are usually marketed as securities-backed lines of credit. The process for obtaining such loans is harder than that of margin loans but easier than that of other traditional loans. Most securities-based lending accounts are backed by stocks and bonds, but other investments such as futures and derivatives can also be used as collateral.
Non-purpose loans are attractive as borrowers continue to receive interest, dividends, and capital appreciation from their portfolio. However, lenders ask for additional collateral (as per requirements stated in the loan agreement) if the market value of the securities falls. Sometimes, borrowers may also be allowed to make partial payments to make up for the fall in the value of the securities.
The interest rates on the loans may be a little higher than traditional loans. Lenders require an additional spread to account for the volatility of the market value of securities given as collateral.
Finally, the proceeds of non-purpose loans cannot be used to invest in or trade securities. However, unlike a purpose loan where the borrower needs to disclose the use of proceeds, non-purpose loans do not require borrowers to disclose the use of proceeds. It means that the borrower can use the loan for any purpose.
Advantages and Disadvantages of Non-Purpose Loans
A key advantage of non-purpose loans is the flexibility they offer. As mentioned above, borrowers can use the proceeds from such loans in any way they like. It makes non-purpose loans ideal for vacations and luxury goods.
Another major advantage of such loans is that borrowers can continue to benefit from interest, dividends, and appreciation of their collateralized portfolio. Furthermore, unlike margin loans that offer credit on a specific account, non-purpose loans can be obtained based on multiple accounts, providing additional flexibility.
There is another reason several borrowers find non-purpose loans attractive. The loan amount or borrowing limit depends on the value of the securities offered for collateral and not on the borrower’s credit rating or debt. It directly lowers the credit requirement to obtain such loans, making the process very swift. Due to the flexible credit checks, the paperwork involved is limited, and borrowers can expect to receive the funds in a couple of days.
Despite the perks of such loans, there are some disadvantages that are important to consider. Due to the volatility of securities such as stocks and bonds, the market value of the borrower’s portfolio may fall below the requirement agreed upon in the loan contract. In such a case, the borrower would need to provide additional collateral or make partial payments.
Some contracts may also trigger liquidation of the borrower’s portfolio if the market value of securities falls below a certain level. Before taking such a loan, borrowers must consider the risk of losing their investment portfolio.
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