Securities-based lending is the practice of lending money to investors who use their securities, such as stocks, exchange-traded funds and others, as collateral for the loan.
Getting a securities-backed loan can be a good way to get some liquidity when you need it without selling a portion of your portfolio. But there are some drawbacks to keep in mind if you’re considering it.
How Do Securities-Based Loans Work?
Securities-based lending is typically offered by large banks, brokerage firms and other financial institutions. Historically, it’s been available to high net worth individuals, but today it’s an option for investors with smaller portfolios. With money management platform M1 Finance, for instance, you need just $5,000 in your brokerage account to be eligible.
For the most part, you can use a securities-based loan for anything you want, but lenders may have some restrictions. If you want to use your investments as collateral to buy more securities, you can look into margin loans instead, which also come with significant risks. You typically can’t use a securities-based loan to purchase or trade securities, refinance or pay off a margin loan or repay any other loan that you used to buy securities.
The loan can come in the form of an installment loan, which must be repaid at a regular interval, or a line of credit, which you can use, pay off and use again.
When you apply for a securities-backed loan, the lender will determine how much you qualify for based on factors like your portfolio balance. You’ll typically only be able to borrow a percentage of what you have in your brokerage account, rather than its full value.
“You won’t be given a dollar-for-dollar loan due to the volatility of the market,” says Tolen Teigen, a certified financial planner and chief investment officer at financial advisory firm FinDec. “It’s not unlike a home equity loan.” While you can typically borrow up to 85% of your home’s equity, the range for securities-backed loans is usually between 50% and 95%, depending on the type of credit, your lender and the collateral.
“Not all securities are collaterizable at the same rate,” says Asher Rogovy, chief investment officer at investment advisory firm Magnifina. “Lenders dictate the amount that can be borrowed against each security.” For example, a bank might allow you to borrow 80% of your corporate bond holdings but only 50% of your stock holdings.
If the loan gets approved, the lender will place a hold on your securities or even keep them in a separate account until you’ve paid back what you owe. During that time, your portfolio will still be subject to market fluctuations, and you may even have gains. But until you’ve paid off the debt, you cannot sell your collateral without approval.
If you fail to meet your payment obligations, the lender can seize the securities you used to secure the loan and sell them to recoup its loss.
Also, if the value of your collateral decreases significantly, you may be subject to a margin call. If that happens, you may be forced to deposit more money into the account, or, if you can’t, the lender may choose to liquidate some or all of your portfolio to cover the margin call.
[Read: Best Personal Loans.]
The Pros of Securities-Based Lending
There are a few reasons to consider using your investment portfolio to secure a loan, especially if you have a lot of value:
— It’s relatively inexpensive. Securities-backed loans typically charge lower interest rates than other types of loans that are unsecured. The rate is usually variable based on an index rate such as the 30-day London Interbank Offered Rate, and the lender generally adds 2 to 5 percentage points on top of that.
— It’s fast. In many cases, you can get funds from a securities-based loan in just a few days. If you need money quickly, you could turn to a personal loan or credit card instead, but interest rates on those types of credit can be higher than on securities-based loans, especially if your credit is less than stellar.
— You don’t have to sell. If you need money for a large purchase or to cover emergencies, you don’t need to sell some of your portfolio. “Instead of having to cash out and realize the taxation, you can keep the money growing and leverage the investment,” says Teigen.
— There are less stringent credit requirements. There’s typically no credit check involved, so if you have a poor credit history but enough invested to get a securities-based loan, this can be an alternative to high-interest credit cards, personal loans and other short-term credit options.
The Cons of Securities-Based Lending
Although there are some clear benefits to using your investment portfolio to secure a loan, it could ultimately cause more trouble than it’s worth. Here are some potential pitfalls to keep in mind:
— You may be subject to a margin call. If the value of your portfolio falls below a threshold set by the lender, you may be forced to add more funds to your investment account to satisfy the lender’s requirements. If you don’t, the lender may choose to liquidate some or all of your portfolio. You don’t have any control over which securities get sold, and the trade may lead you to owe more taxes.
— You may lose your portfolio. If you can’t keep up with your payments on your securities-backed loan, the lender may decide to seize your assets and use them to cover what you owe. This is similar to the repossession of a vehicle on an auto loan or a foreclosure on a mortgage. When this happens, you may be subject to taxes based on the value of the securities at the time of the sale.
— Your portfolio access may be restricted. Since your securities are being used as collateral for the loan, you won’t have access to certain account features. For instance, you may not be able to withdraw assets without permission. If you want to move your investing to a different firm, you may need to repay your loan first.
— Interest is often variable. “Securities-backed loans are often based on a floating interest rate that could move from month to month,” says Rogovy. While that might not make much of a difference during times of low interest rates, it can get expensive if interest rates increase significantly.
How Does Securities-Based Lending Impact Your Credit?
Securities-based lenders may or may not run a credit check when you apply for a loan, and they may not report monthly payments to the credit bureaus. As a result, you won’t experience any credit impact from a securities-backed loan, either good or bad.
[READ: Best Bad Credit Loans. ]
That said, it’s important to check with the lender before you apply to understand how it handles your credit and what effects there may be if you go ahead with the loan.
Is a Securities-Based Loan Right for You?
If you’re considering using your investment portfolio to secure a loan, it’s important to understand both the benefits and the drawbacks of the process.
While it can be easy and inexpensive to secure funds using your securities, you may run into serious issues if the value of your portfolio drops significantly. As a result, it’s crucial that your portfolio is diversified to minimize risk. “It’s in the interest of both parties that the value of the securities remains stable so the lender doesn’t have to liquidate them,” says Rogovy.
What’s more, it may be worth it to consider using just a portion of your portfolio as collateral to limit your risks even further. For example, if you can borrow up to 50% of your account value, consider borrowing just 25% or 30% instead.
Before you apply for a securities-backed loan, take a moment to consider whether you actually need the cash in the first place — just because it’s easy and cheap financing, it doesn’t mean it’s necessary. “Should you take on this debt, no matter how you secure it?” says Teigen.
[Read: Best Home Improvement Loans. ]
If you’ve determined that borrowing is necessary, consider other options that may come with fewer risks. For example, while credit card interest rates may be higher, you could avoid paying interest entirely if you can get the money to pay off your balance before your statement’s due date. And while an unsecured loan may charge more, too, you won’t have to deal with potential margin calls or the liquidation of your assets.
As with any financial decision, it’s critical that you take the time to research all of your options before moving forward.
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What Is Securities-Based Lending? originally appeared on usnews.com
