Should You Take Out a Loan Backed by Your Investments?

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If you have a taxable investment account, you may have heard from your bank or brokerage lately about the opportunity to borrow against your stock holdings. There are many attractive aspects to securities-based loans, which have gained popularity thanks to marketing campaigns. But there are also reasons to be cautious about this kind of borrowing.

Financial firms tout these loans as a convenient and affordable way to access quick cash for anything from a kitchen remodel to bridge financing for a home purchase. What they might not mention is that they have a strong incentive to get you to take out the loans; lending is seen as a good source of reliable income for brokerage firms looking to reduce their reliance on commissions.

Securities-based loans (also known in the industry as non-purpose loans and securities-based lines of credit or SBLOCs) have risks, which led the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) to issue a consumer warning about them.

The benefits of securities-based loans

It's not as if your broker is lying if they tell you that taking out a securities-based loan can be a good way to get liquidity when you need it. There are real benefits.

1. Low rates

Brokerage firms have been issuing securities-based loans at rates lower than what you'd pay on a personal loan or credit card balance, and competitive with or better than what you'd pay for a home equity line of credit.

2. Lenient application process

In a 2015 investor alert, the Securities and Exchange Commission noted that "some SBLOC lenders might not run a credit check or conduct an analysis of your liabilities before setting and extending the credit line." Since the lender has your stock as collateral, they don't need to worry too much about whether you can pay back the loan.

3. Fast turnaround

Funds are typically available less than a week after applying. This speed can be clutch if, say, you are in a competitive bidding situation for a house and want to have a down payment and earnest money ready at the drop of a hat.

4. Keeping your stock (and avoiding taxes)

Of course, if you have stock and you need cash, you could simply sell the stock to pay for what you want to buy. One reason some investors prefer to borrow against their portfolio value is the potential tax advantage: By keeping the stock, they avoid registering a capital gain, which they'd have to pay tax on that year. This benefit may be particularly valued by retired people who hope to hold onto their stock for life and pass it on to their heirs, since the cost basis will be stepped up to the market value at the time of death. This means that any new capital gains will be based on the price of the stocks when they were transferred to an heir, and not the price when they were first purchased.

Another situation when avoiding selling stock might really come in handy: If you bought the stock within the past year and want to wait a year before selling it to qualify for the long-term capital gains rate, which is lower than the short-term rate. (The short-term rate is the exact same rate as your ordinary income.)

Finally, keeping your stock means retaining the benefits of ownership, including any dividends, voting rights, and potential future gains.

The risks of securities-based loans

With all those pluses, why did the SEC and FINRA warn us about this kind of loan? Because they come with risks that may not be immediately apparent to the borrower.

1. The maintenance call

If you buy a house and the housing market crashes, you may end up owing more than the house is worth; but at least you can keep your home as long as you can make the payments. Not so with securities-based loans.

"SBLOCs are classified as demand loans, which means lenders may call the loan at any time," the SEC warns. Typically, this would happen if the market goes down and the value of the securities you're borrowing against decreases sharply; the lender would make what's known as a "maintenance call," demanding that you pay all or part of the loan. If you can't, the lender will sell your stock at the current price. If this happens, you'd basically be forced to sell at the worst possible time.

What are the odds of this happening? No one can see the future, but the current bull market is considered downright elderly at eight years old, leading many experts to predict a correction or recession sometime soonish. It would be foolish to expect the value of your portfolio to always rise and never fall.

2. Variable interest rates

As with any loan, read the fine print before signing on the dotted line. Many securities-based loans charge variable interest rates, meaning that you will never know how much your interest expenses will be each month.

3. Unexpected tax bill

If you bought a stock at a low price, borrow against it at a higher price, and it dips to a price between those two prices, it could spell tax trouble. If the lender forces a sale to pay the loan, you'll owe capital gains tax on the difference between your purchase price and the sale price — which could really sting if the sale proceeds went to pay off the loan, leaving you with no cash.

4. Lost freedom

The SEC warns that you will likely have to pay off any securities-backed loans before moving your assets to another brokerage firm — which could be another reason that brokerages are pushing these loans.

So should you get a securities-based loan?

While your broker's suggestion that you get a securities-based loan might be laden with self-interest, that doesn't mean you have to say no. Weigh the pros and cons before deciding, and consider taking these measures to safeguard the process if you go ahead.

1. Borrow less than you qualify for

Lenders are offering clients loans worth as much as 95 percent of an investment portfolio. The lower the percentage of leverage, the safer you are against the risks of securities-based borrowing.

2. Borrow only against a diverse portfolio

If you only own stocks in the energy sector, it won't take an overall downturn to cause a securities-based loan disaster; a sharp downturn to that one sector could do it. Investing in diverse sectors is always a good idea, but even more so if you're borrowing against your holdings.

3. Have a maintenance call plan

If you can put up the additional funds the lender demands in a maintenance call, you won't be forced to liquidate your shares at an inopportune time. So figure out in advance other ways to meet that maintenance call, whether it's tapping an emergency fund, borrowing from family, or liquidating other assets.

4. Don't borrow to pay for something without resale value

The marketing materials brokerages use to encourage securities-based loans mention vacations. But if your loan gets called in, you can't sell your vacation memories to raise the necessary cash.

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