What securities-based loans are and why physicians should consider them as part of their borrowing repertoire.
Debt is a four-letter word, and some even consider it so in the figurative sense. But debt can be a useful financial tool when employed properly. Many people associate high-interest credit cards with bad debt and think of mortgages and home equity lines of credit as good debt, because they allow a borrower to purchase a home or help finance other important goals that would otherwise be out of reach. However, we’d like to inspire doctors and other health care professionals to consider another type of borrowing: a securities-based loan.
A different kind of loan
Lenders have different names for this type of borrowing, including pledged asset line, securities-based loan, or portfolio line of credit. But whatever they are called, the idea behind them is the same: that a bank can make a relatively safe and lucrative loan secured by a borrower’s own portfolio. Specifically, a borrower pledges as collateral marketable securities in his or her non-retirement account(s). Banks are willing and perhaps eager to make these loans, given their net interest margin (essentially the difference between the interest banks earn on their loans and the interest banks pay on customer deposits).
Borrowing against one’s own portfolio is not a new strategy, but it’s worth a fresh look given the current financial climate – a climate characterized by inexpensive borrowing rates, rather stringent lending standards, particularly for those with little current income, and portfolios that likely have substantial unrealized capital gains.
The release rate, i.e., how much a bank will lend against the collateral’s value, often depends on the type of collateral. For instance, cash equivalents and US Treasury bills are viewed by lenders as very reliable collateral and will often allow a generous release rate, usually around 95%. In other words, you can borrow up to 95 cents for every dollar of collateral in your portfolio.
For many other common marketable securities such as stocks, mutual funds, and exchange-traded funds, banks will often assign a release rate of around 70%. It is worth noting that there are assets against which banks are not comfortable lending at all, such as thinly-traded stocks and closely-held businesses.
An alternative to mortgages
When exploring lending solutions, doctors would be wise to consider all available options. A traditional mortgage is, of course, something to consider and offers several advantages, including the potential to secure a long-term, fixed-rate loan often unavailable to those considering a securities-based loan. Additionally, the interest on a traditional mortgage can be is tax-deductible.
Our clients are using securities-based loans more in the current environment than they had previously. In our experience, this choice is often driven by a need for short-term financing, the necessity to explore non-traditional lending options, or as a just-in-case line of credit.
For example, a client may be selling an existing home and buying a new one. Sometimes the timing works out nicely. But sometimes the down payment on the new home is needed before the sale of the existing home closes. In these instances, a securities-based loan can bridge the gap while allowing one’s portfolio to remain intact and avoiding any potential capital gains consequences of liquidating investments.
Importantly, it can pay to negotiate. As noted earlier, banks like these loans because they are profitable. So letting them know the loan will be used for a specific purpose, versus merely as a just-in-case line of credit, will provide them incentive to offer a more attractive interest rate.Financial advisors sometimes have relationships with lenders offering securities-based loans and can help negotiate further. For example, our firm is often able to secure interest rates markedly lower than those on mortgages and home equity lines of credit.
Consider the pros and cons
While a securities-based loan can be a great option for some, it won’t work for everyone.Retirement assets such as those is an IRA or 401(k), sometimes the largest portion of an investment portfolio, usually cannot be used as collateral. Additionally, this strategy carries some risk. If the value of the collateral declines, such as in a financial market correction, the borrower may be forced to pay down some of the loan. If the borrower does not have additional money to do so, the bank can force the sale of pledged collateral.
Borrowers must be cognizant of this risk, which some argue is elevated now since financial assets are expensive by numerous traditional valuation metrics. Accordingly, a prudent strategy is often to establish the largest line of credit possible given the value of the collateral, but not borrow the maximum amount permitted. The rationale behind this strategy is to secure the most attractive interest rate possible while still allowing some cushion, and providing peace of mind, should the value of the collateral decline.
Here’s a real-life example. A couple who are clients of ours, we’ll call them Mark and Sara, wanted to purchase a vacation home. Since they are mostly retired, they did not have the earned income required by most traditional mortgage lenders. And although Mark and Sara have sufficient assets to buy the home outright, they were looking for alternatives that would allow them to capitalize on the near-record-low interest rates available to borrowers. We were able to help them secure a securities-based line of credit for over $1 million with an interest rate of less than 2%.
Mark and Sara borrowed approximately $500,000 (about half the purchase price) so that they could leave their portfolio intact for longer, earn a return that exceeds the sub-2% interest rate on their loan, and avoid the capital gains they would have incurred if they sold investments to buy the home outright.
As long as a borrower understands the risks, a securities-based loan provides the potential for very attractive interest rates, allows the borrower’s investment portfolio to remain intact, and may provide a lending option when others may not be viable. Additionally, there are usually no costs to establish a securities-based loan and it is generally simpler and faster to obtain than a traditional mortgage.
For these reasons, a securities-based loan should be part of your borrowing repertoire. Remember to establish the largest line available, negotiate the interest rate, and leave a cushion when borrowing. Do these things and enjoy the same success as Mark and Sara.
Daniel J. Duca, CFP, is associate director at Altfest Personal Wealth Management