Lesson 11 of 25 · 6 min
Tracing: what the borrowed money was used for
The collateral does not characterise the loan. The spending does, and only for as long as the spending can still be followed.
A common instinct is that the character of a loan follows the collateral. In many systems it follows the money instead — specifically, what the money was spent on.
This is tracing. The borrowed amount is followed from the account it landed in to the things it bought, and the interest is allocated across those uses in proportion. The collateral does not enter the calculation anywhere. The same pledged portfolio can support interest of three different characters at once, because three different things were bought with the proceeds.
Suppose $840,000 is split three ways: $505,000 into income-producing assets, $210,000 into a residence, and $125,000 into consumption. At an assumed 6.85 percent, total interest for the year is $57,540. The allocation is arithmetic on the principal, because the rate is common to all of it: $505,000 × 0.0685 = $34,592.50, $210,000 × 0.0685 = $14,385.00, and $125,000 × 0.0685 = $8,562.50. Those three sum to $57,540. Three characterisations, one loan, one lender, one pledge.
The fragile part is evidence. Tracing requires that the path from draw to use is still visible, and it stops being visible when borrowed money is commingled with other money and spent from the mixture. At that point a default ordering rule decides the allocation, and that rule was not written with anyone's preferences in view. Lesson 12 works through what it does.
The mechanism is general; the treatment is not. Systems differ on whether tracing is used at all, on how long a trace survives, on what documentation sustains it, and on which uses qualify. Those are questions for a holder's own adviser and their own records.
Key terms
- Tracing
- Following borrowed money from the draw to what it bought, so the interest can be allocated to those uses rather than to the collateral.
- Use of proceeds
- What the borrowed money was actually spent on. Under a tracing approach this, not the pledge, characterises the interest.
- Commingling
- Mixing borrowed money with other money in one account, after which the path to a particular use can no longer be demonstrated.
Worked example
One loan, three characters
A single $840,000 draw against one pledged portfolio, at an assumed 6.85 percent, spent on three different things.
- Total drawn
- $840,000
- Interest for the year
- $57,540
- Traced to income-producing assets
- $34,592.50
- Traced to a residence
- $14,385.00
- Traced to consumption
- $8,562.50
- Collateral behind all three
- The same portfolio
$840,000 × 0.0685; the rate is an assumption of the example.
$505,000 × 0.0685.
$210,000 × 0.0685.
$125,000 × 0.0685. The three sum to $57,540.
The pledge was identical across every dollar. The character of the interest split three ways on the spending alone.
Check yourself
An $840,000 draw against one portfolio at an assumed 6.85 percent is spent $505,000 on income-producing assets, $210,000 on a residence and $125,000 on consumption. How is the $57,540 of interest characterised?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.