Is Securities-Based Lending a Good Idea?

Once reserved for the ultra-wealthy, securities-based lending found a following in recent years as a popular source for funding luxury items, real estate and small businesses, among other things. While promoted as a great way to put your unrealized gains to work for you, investors should consider treading carefully.

What Is Securities-Based Lending?

Securities-based lending is the practice of borrowing money while using securities held in your after-tax investment accounts as collateral. Generally, these types of loans are made available by the larger banks and financial institutions, brokerages or advisory firms. The interest rate is typically lower than other forms of credit and is based on the short-term index, such as London Interbank Offered Rate (LIBOR) plus a spread determined by your loan amount.

The instrument through which you tap the value of your securities is called a securities-based line of credit (SBLOC), which allows you to borrow money and make interest-only payments while the loan remains outstanding. Usually, you can receive funds within a matter of days.

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With an SBLOC, the lender becomes the lienholder. Often, you can borrow 50%-95% of your eligible assets, depending on the value of your holdings, types of collateral and your credit score. You can also continue to buy, sell and trade securities in your pledged accounts, but it is important to note that the loan funds cannot be used for other securities-based transactions, including purchasing and trading. Additionally, SBLOCs are fairly “sticky” in that it is difficult to move your pledged assets to a new firm once an account has been opened.

Uses for Funds

Such loans provide easy access to capital and enable the borrower to avoid having to sell securities to tap their funds. Examples of uses include:

Personal

• Real estate and bridge loans
• Tax payments
• Tuition
• Large purchases
• Luxury goods and personal property
• Weddings
• Travel
• Unexpected emergencies

Business

• Investing in a business
• Expanding a business
• Short-term capital expenses
• Interest in a business partnership
• Liquidity for estate planning
• Acquisitions
• Startup seed funding

What Collateral Can Be Used?

Though not used solely by the ultra-rich anymore, securities-based loans are generally limited to those clients with significant capital and high net worth. Your lender will determine the value of your loan based on the value of your investment portfolio. You would then execute an SBLOC contract that specifies the maximum amount you can borrow. When approved, the securities used to secure the loan will be deposited into an account while the lender becomes the lienholder of that account.

The types of collateral your lender may allow include:

• Stocks
• Investment-grade bonds
• Treasury, municipal and government agency bonds
• Mutual funds
• Hedge funds
• Equities
• Exchange-traded funds (ETF)
• Cash and cash equivalents like certificates of deposit

To use your SBLOC funds you should have access to checks provided by the firm, wire transfer, electronic funds transfer or ACH payments.

Advantages of Securities-Based Lending

Securities-based lending has multiple advantages for investors looking to access quick cash, including:

Lower Cost: The setup is cost-effective with no setup fees and only the funds incur an interest charge, which is often lower than other lending options, such as a line of credit, home equity and credit card.

Financial Flexibility: With quick access to money, the loan is perpetual, or with no maturity date, allowing you to repay and borrow again later as often as you like.

Tax Efficiency: These types of loans can provide a tax-efficient option for avoiding capital gains that would normally occur from selling your securities.

Credit Agnostic: These loans do not generally show up on a borrower’s credit report.

Disadvantages of Securities-Based Lending

There are multiple disadvantages of securities-based lending that investors should be aware, including:

Increasing Rates: Depending upon the type of loan taken, if interest rates rise it could create a spike in the rates that apply to your SBLOC, and ultimately erode the value of our account, depending on the type of collateral in your account.

Liquidation: If you default on your loan repayment, your lender can liquidate your securities. What’s more, lenders can decide to liquidate these assets without notifying you.

Risk of Margin Call: Should the investment value fall below the collateral value, a margin or maintenance call may be forced, causing you to liquidate. Because the loan may be mismatched in liquidity, it might be difficult to unload the collateral fast enough to repay the loan. If you are unable to post the additional collateral or funds required within a few days of the call, your lender may liquidate your securities to satisfy it.

Potential Tax Consequences: Should your assets be liquidated to cover a margin call, there could be tax consequences involved.

Potential for Bubble: If loans go bad all at once, investors could get caught up in a bubble. On a larger scale, such a bubble could have implications for the market, should everyone decide to sell off their portfolio at the same time.

Final Thoughts

A boon for wirehouses in the last handful of years, securities-based lenders have generated revenue through cross-selling to wealthy customers. We recommend exercising caution before you consider pledging your securities as collateral for vanity purchases. If your securities firm offers an SBLOC through a third-party lender, you should ask your adviser how they will monitor your account and how and when you will be notified of a collateral shortfall that might result in a margin call.

These types of loans may not be the best option for investors who are worried about risks and the potential for undermining their retirement. As always, we recommend you seek the advice of a trusted financial adviser to help you navigate the world of securities-based lending.