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Purpose loans are loans that are backed by a series of securities, and are extended for the specific purpose of purchasing other securities. This type of loan strategy is often utilized by investors as a means of securing the resources to acquire the securities without making use of the resources already on hand. In many cases, the securities that are acquired generate enough return to cover the loan payments, allowing the investor to eventually own the securities outright without ever committing his or her other financial assets to the acquisition.
Purchasing securities using a purpose loan is a process that is considered legal in most nations around the world. Typically, the specifics of the deal, including the type of securities that are used to back the loan, must meet the qualifications put in place by governmental regulatory agencies. For example, in the United States, every purpose loan must comply with the margin requirements put in place by the Federal Reserve Board, both in terms of the provisions associated with the loan and the nature of the backing securities.
Regulations of this type help to protect the borrower from investing in a loan that does not have sufficient financial backing, as well as to prevent the imposition of terms that are vague or require commitments that would be difficult to honor throughout the life of the loan. Lenders are also afforded a degree of protection, as the governmental regulations also set standards that borrowers must meet before the purpose loan is granted. From this perspective, lenders are protected from extending loans to borrowers who fail to meet the basic criteria, and avoid incurring an unreasonable amount of risk. Under the best of circumstances, the regulations protect the interests of both parties equally, and enhance the potential for the transaction to ultimately benefit everyone involved.
The purpose loan is intended for a different purpose than the non-purpose loan. While both loans are backed by qualified securities, the non-purpose loan is not intended for use in purchasing other securities, or a tool to aid in carrying or trading securities. Typically, with a non-purpose loan, the borrower must declare the reason he or she is seeking the loan, making it possible to exclude any possibility of the proceeds being used for an unauthorized project. There are no such restrictions on the purpose loan, and the funds received from the loan can be used for any type of investment project.