Preparing to make a real estate purchase? Putting an addition on your house? Many people looking to make a large cash outlay may find it challenging to do so without taking out a traditional loan from a bank or selling investments and triggering tax liabilities. But there is a lesser-known financing option that may be attractive for investors: securities-based lending.
Securities-based loans (SBLs) enable investors to use their investments as collateral to borrow cash at cheaper rates than mortgages and home equity lines of credit — all without losing valuable market exposure in their portfolio. We provide an overview of SBLs and how they can help you achieve your financial goals today.
What are securities-based loans?
Banks and other lenders lend money to individuals using marketable securities from the borrower’s investment portfolio as collateral. Any securities with daily liquidity, including stocks and bonds, may qualify as collateral.
An individual seeking an SBL typically can borrow around 50% of the market value of the collateral, depending on the types of securities used. For example, if an investor makes $1 million of Ford Motor Co. stock available as collateral for an SBL, the investor should be able to obtain a line of credit of approximately $500,000. Investors with more diversified collateral, such as an S&P 500 Index fund rather than a single stock, often can obtain a larger line of credit.
An SBL borrower posts investments from their portfolio as collateral for obtaining the loan. The securities continue to be held as an investment for the borrower’s benefit — meaning investors avoid triggering capital gains/taxable events when securities are collateralized. The pledged securities continue to appreciate (or depreciate), allowing the investor to generate liquidity without disrupting the overall investment strategy. A borrower typically can increase the size of the line of credit by request if collateral appreciates in value and/or the borrower adds collateral to pledged accounts.
Investors mostly use SBLs to finance short-term spending needs, such as real estate purchases and home-improvement projects. However, there is one important caveat: Borrowers may not use the proceeds from an SBL to buy additional securities and “lever up” a portfolio.
Attractive interest rates and other features of SBLs.
Interest rates on SBLs are typically variable and calculated using the current 30-day London Interbank Offered Rate (LIBOR) plus a spread, which generally ranges from 2% to 5%. SBLs typically include an interest rate ceiling, which prevents lenders from charging more than a specified amount in interest. Rates on SBLs generally are lower than rates on traditional bank loans and home equity lines of credit (HELOCs). The larger the line of credit is, the lower the interest rate a borrower can receive.
Borrowers only pay interest on the amount they draw from the line of credit. For example, if the borrower taps $100,000 from a $500,000 line of credit, they will be charged interest only on the $100,000. Another attractive feature of SBLs is that they have greater repayment flexibility relative to traditional loans. Because an SBL is a “cash-flow-neutral” line of credit, the borrower can either make interest payments or let interest accrue, as long as there is sufficient credit available and the borrower pays off interest by the end of the term.
In addition to offering competitive interest rates, SBLs generally are more accessible than a HELOC, traditional bank loan, or mortgage. The turnaround time for getting an SBL can be as short as five days, depending on the borrower’s credit profile and available collateral. One additional advantage of SBLs in the competitive real estate market: When using an SBL to finance a real estate purchase, a buyer can represent himself as a “cash buyer” to the seller and pivot to a conventional mortgage after making the purchase.
Key risks to consider.
The primary risk for an SBL is the market risk of the collateralized securities. If the collateralized securities decline in value significantly, the borrower may face a margin call and be forced to sell securities to pay the loan or add more securities to the collateral pool to satisfy the loan terms. Securities-based loans are not tracked or monitored by regulators or industry watchdogs such as the SEC or FINRA.
Borrowers should also be aware of interest rate risk. Because SBLs typically have variable interest rates, the rates on a loan could rise. The Federal Reserve recently said it would begin raising key rates as soon as 2022, which means today’s low interest rate environment is unlikely to last.
Is a securities-based loan right for you?
Securities-based loans are generally an under-utilized source of credit that can benefit many investors. If you are interested in making a large cash outlay but don’t want to sell assets and disrupt your portfolio, an SBL may be a good fit. As fiduciaries, Leelyn Smith’s team of advisors can work closely with you to analyze your options and determine the best path forward.
For more information about securities-based loans and how Leelyn Smith can assist with your specific financing needs, don’t hesitate to get in touch with your Leelyn Smith advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.