Stock loans can put your securities to work as collateral

August 1, 2011

A few years ago, homes provided a deep and seemingly endless pool of loan collateral. Now, depressed real estate values and tight lending standards are prompting some brokers to float the idea of using stocks and other securities as collateral for people with healthy portfolios but limited borrowing options.

As the name implies, securities-based loans rely on the value of stocks, bonds or mutual funds as collateral. The most common form of a securities-based loan is a margin loan, which typically allows you to borrow up to 50 percent of the value of stocks in your account, and a higher percentage for less volatile assets such as Treasury or municipal bonds.

Another type of securities-based loan, called a non-purpose loan, follows similar collateral rules but often carries better rates and terms than a garden-variety margin loan. These are usually for larger amounts of $100,000 or more and are arranged by brokers or bankers for their most well-heeled clients.

In either case, custodial and retirement accounts, including IRAs, are off limits in these transactions.

While most people are familiar with margin as a way to finance stock purchases with borrowed money, the loan proceeds need not be used for investments. In fact, there are no restrictions on what you can do with the money and no set schedule for paying it back.

Margin loans fell out of favor in 2008, when the stock market crash forced many people to add collateral to their accounts at a time when they could ill-afford to do so. But the market recovery has sparked a comeback and over the last year margin debt at New York Stock Exchange-member companies has risen from $236 billion to nearly $316 billion.

While it’s hard to say how much of that money is going toward personal use, securities-based loans are filling a gap for some people whose borrowing capacity has been choked off by the recession.

Scott P. Strochak, a wealth adviser at Morgan Stanley Smith Barney in Boca Raton, Florida, has used non-purpose loans backed by stocks and other securities for some clients with high-interest mortgages whose decimated home values preclude them from refinancing.

He cites one client who purchased a house a few years ago during the real estate boom for $5 million, and had a $3 million, 30-year mortgage with a 6.75 percent interest rate. Because his home value had been cut in half, he was underwater on his mortgage and could not refinance to a lower rate.

Strochak suggests he take out a conventional mortgage for $1.1 million and combine it with a $1.9 million five-year securities-based loan with a 3.5 percent fixed rate to refinance. The combined rate for the two loans was an attractive 3.68 percent.

He says other clients have used securities-based loans as a short-term financing bridge while they wait for a house to sell, to fund nursing home expenses or even for emergency situations such as repairing a roof.

“This is a good tool for people who don’t want to liquidate securities to raise money they need,” he says. “It provides flexible access to the power of a portfolio.”

James Hotzman, a financial adviser with Legend Financial Advisors in Pittsburgh, says a number of his clients have used similar loans over the last few years. One of them had trouble refinancing a commercial mortgage loan through conventional channels because of the property’s drop in value. Another turned to a securities-based loan when he found it difficult to obtain financing for a home construction.

“In certain situations these loans can work out really well,” he says. “But it’s not something we typically recommend because of the risks involved.”

Chief among those risks is the dreaded margin call. If the collateralized securities drop substantially in value, the brokerage firm could demand that you raise the equity in the account by adding cash, depositing additional securities or selling some of the securities in the account. Brokerage firm rules generally require equity of at least 25 percent of the current market value of the securities, although many set that bar a bit higher.

As an example of what could happen, assume you have a $100,000 portfolio of stocks and use it to as collateral for a $50,000 loan. If the value of the portfolio drops to $60,000 and the loan amount remained the same, you’d need to come up with an additional $5,000 to keep the equity in the account at an acceptable level. Otherwise, the broker is free to sell additional securities from your account to bring the equity balance up.

Rates on smaller loans can also be quite expensive. At several discount brokers, a $20,000 margin loan carries an interest rate of over eight percent, compared to less than five percent for a typical home equity line of credit. Rates for loans of at least $500,000 can be four percent or even less, but most people don’t have enough collateral to pull it off. And, paying off a typical margin loan can actually raise your interest rate, since the rate increases as the loan balance becomes smaller.

Given these risks, securities-based loans are more appropriate for funding essential purposes where other loan options are closed off rather than discretionary items. If you are considering one, here are some steps you can take to manage risk:

  • Don’t borrow the maximum allowed and use less volatile securities for collateral; both measures will help prevent a margin call.
  • Pay them off as soon as possible, the market will have less time to work against you.
  • Monitor your securities: If you see they’re declining in value, consider adding additional cash or securities to avoid a margin call.
  • Don’t be an accidental margin borrower. Taking out a margin loan is deceptively easy, and it’s possible to do so without even knowing it by writing a check for more than the cash balance in a brokerage account. The check won’t bounce. Instead, the transaction will appear as a negative balance, and you will be charged the going margin interest rate.

With the wide difference between the measly rates they pay out for money market deposits and high margin loan interest rates, brokerage firms rake in a lot of profit from these transactions. Don’t make them richer by accident.

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“The most common form of a securities-based loan is a margin loan, which typically allows you to borrow up to 50 percent of the value of stocks in your account, and a higher percentage for less volatile assets such as Treasury or municipal bonds.

Most munis are tax-exempt, and you can’t buy tax-exempt bonds on margin. Tax regulations prohibit it.

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