Due to the strength of the economy, investment professionals have been offering another solution for those in need of some quick cash—securities-based loans. There are a lot of benefits that come with such a solution, however, it can also be potentially dangerous. As the bull market continues to age, such a proposal continues to be eyed with more skepticism as market experts predict a correction or a recession. However, before we get into the benefits and hazards of such a loan, let us define it first.
What is a securities-based loan?
A securities-based loan, which also goes by the name of non-purpose lending, “allows an investment firm to extend an investor a line of credit without selling the assets backing the loan, much as the once popular home equity line of credit (HELOC) allowed banks to extend credit to homeowners without touching the underlying home,” according to “A Dangerous Game: Using Your Portfolio as Collateral.”
Potential benefits of this loan type
Unlike other loans or credit cards, a securities-based loan has lower interest rates making them highly competitive. Unlike other loans that require a credit check, lenders might not run your credit since they have your stock as collateral and can sell it if need be. If you are in dire need of quick cash, the turnaround is fast, according to “Should You Take Out a Loan Backed by Your Investments?” The funds can become available in less than a week after applying. Moreover, the best part about this solution is that you do not have to sell your stock to get the cash—you can keep ownership.
What is the catch?
Sounds like a pretty sweet deal so far, right? Not so fast. With this particular loan, there is some added risk that you may not have thought of. As mentioned before, the lender is able to sell the stock if need be. These loans are defined as demand loans which means that the lender can choose to call the loan anytime.
This can occur if the value of the securities that you have borrowed against decreases significantly. If this happens, the lender can call to have you pay in full or make a payment on the loan. If you are unable to, then the lender can force you to sell the stock at its current value, which is not the most ideal situation.
Another downside to this type of loan is, although the interest rates may be competitive, you should understand that many of these kinds of loans usually have variable interest rates. This means that you never know how much you will have to pay each month in interest.
Is it worth the risk?
If you only have stock in a particular sector, then obviously the risk is greater. But if you have a diversified portfolio, you can reduce the risk that comes with borrowing against your investments. Moreover, you should have a plan in the event that the lender calls on the loan. Ultimately, you need to weigh the benefits against the risk to determine if it is really worth it. And take steps to reduce the risk as much as possible if you do intend to sign on the dotted line.