What Can I Use My Loan Money For?
Is it Illegal to Find an "Alternative Use" for the Money?
When you borrow money, you might end up with more cash than you need. It is especially common with student loans and auto loans (whether it happens intentionally or by accident). When that happens, what can you do with the money – are you allowed to spend it on anything you want?
To find out what's allowed, check your loan agreement. In some cases, there are restrictions, but other loans allow you to do whatever you want with the money.
Some people even take out loans without any intention to use the money the way the bank thinks they will. The most brazen borrowers invest the money, hoping to earn more than they pay in interest (also known as a "spread"). Others simply use the funds for daily living: paying bills, buying groceries, and so on.
Loans for a Specific Purpose
With some loans, lenders want to restrict how the funds are used. Loan interest rates typically take into account the risk that the lender expects to take, and that depends in part on the purpose of the loan. Riskier loans have different terms and are more expensive than less-risky loans.
You might not even be able to get certain loans unless the money goes toward a specific purchase.
Home loans (or mortgages) are generally used to purchase a home or refinance an existing home loan. It's virtually impossible to get that money unless you go through a closing process which involves using the property as collateral for the loan.
That way, if you stop making payments, the lender can foreclose and sell the property to get their money back.
What about taking cash out? If you have significant equity in your home, you can borrow against it – but you risk losing your home if you can't repay the loan. Taking cash out in the form of a home equity loan or line of credit allows you to use the funds for almost anything.
Auto loans are similar to home purchase loans: the vehicle you buy secures the loan, so the lender takes less risk. You generally don't get a clear title in those cases – your lender has a lien on the vehicle until you pay off the loan. This makes it harder for you to sell the car for cash. That said, auto loans tend to be smaller than home loans, so lenders are not as strict. You might be able to get a check for as much as 110% of the car's value, leaving some extra money for registration and similar expenses.
Student loans are especially tricky. The government subsidizes some student loan interest costs because an educated population is considered a good investment. Furthermore, banks are willing to offer attractive student loans because college-educated adults will be more likely to have the income needed for repayment.
With student loans, you end up with a large sum of money in your bank account, and nobody watches to see what you do with the funds. You're supposed to spend that money on expenses related to higher education, but what does that mean? Tuition and fees are obviously acceptable expenses, as is rent (but should you rent an expensive place?). A vacation or a new TV is usually not an acceptable expense because you don't need those things to complete your education.
Business loans are also likely to come with restrictions. For example, Small Business Administration (SBA) loans can only be used to operate your business. You can't use them to pay off other debts, buy something in hopes of an increase in value, or for any purpose "that is not considered to be a sound business purpose as determined by SBA."
Personal loans can be used for pretty much anything. You don't pledge collateral, nor do you agree to use the money for a specific purpose. Personal loans include credit cards and signature loans from your bank or credit union. Loans from online lenders and peer-to-peer lenders are often personal loans as well.
Check your Agreement
If your contract/agreement says that you must use the funds for a certain purpose, you're taking a risk by doing something you agreed not to do.
If you fail to keep your end of the bargain, the lender may choose to end the agreement and demand that you return the money (in other words, you'd have to repay the loan in full immediately). Getting the money back quickly and without cost may be a challenge. For example, you may have to pay a penalty for early distribution from a CD, or you might not have the money available anywhere – which would cause you to default on the loan.
Is it Illegal?
Technically, using your loan money for "alternative" purposes might not be illegal. However, there is a risk that your lender will take legal action against you (if they find out that you’ve used the money in a way that's different from what you promised and you default).
Getting creative with your loan money can result in several problems. First, you might find yourself deep in debt, and you'll have to repay those loans at some point. Student loans can be especially troublesome. Those debts are hard to wipe out – even in bankruptcy – so they'll haunt you for life if you get in over your head.
Even an auto loan can cause trouble. If you borrow too much, you'll find that you owe more on the vehicle than it is worth (also known as being upside down). As a result, you'll have a hard time selling the vehicle – you'll have to write a check to get rid of it – or you'll keep making payments long after the car is worthless.
Some lenders set minimum loan sizes and might require that you borrow more than you need. If that happens to you, don't treat the money as a gift. Use it pay off other debts, or send that money right back to your lender (assuming there is no prepayment penalty).