Securities based loans were once reserved for the ultra wealthy. Over the past decade they’ve become increasingly common and more popular as brokers look for new sources of revenue. Are these loans really some secret tool of the wealthy? Or is this just the rich man’s subprime?
What is a Securities Based Line of Credit?
A Securities based line of credit is a non-purpose loan backed by a portfolio of investment securities. While a mortgage uses your house as collateral and an auto loan uses your vehicle, your investment portfolio acts as collateral for a securities based loan. As a non-purpose loan these lines of credit can be used to finance virtually anything you want. A typical line of credit permits you to borrow up to 50-95% of your investment account.
The Positives:
Obtaining a securities based line of credit is generally a very quick/easy process and can offer very low rates. This is because your investment portfolio is considered liquid and can be easily sold by your custodian to repay your loan. Thus there is far less consideration of your cash flow, income or credit score compared to more traditional loans. For instance, Goldman Sachs boasts that their loans require no personal financial statements or tax returns.
Interactive Brokers offers some of the lowest rates of any broker or custodian. Their current rate for a securities based line of credit for borrowings over $1M is a benchmark rate + .75%. That benchmark rate at the time of this writing is only .08%, making the total rate 0.83%.
The Negatives:
If your portfolio drops significantly, you will be forced to post additional funds or your investment account will be liquidated. This is the dreaded margin call that has destroyed the wealth of many speculators. Making such a margin call additionally punitive is that it would likely come during a market drop, precisely the time that equities are becoming more attractive and an investor should be rebalancing their portfolio and buying instead of selling.
Securities based lines of credit have adjustable interest rates. While the rates are generally very low today, the market has made it very clear that short term rates are set to rise significantly in the next 12-18 months.
Who Would Benefit from a Securities Based Line of Credit?
I think the best application of a securities based line of credit is when one wants to finance a short term purchase or goal when quick access to capital is advantageous. One of the common uses is real estate bridge financing. A securities based line of credit could help you make a more competitive offer on a new home that is not contingent on selling your current home. Then once you’ve sold your original home you can pay off the line of credit. In this scenario the line of credit would allow you to make an offer without worrying about how quickly you sell an existing home and without having to sell off securities to raise capital. When you have a portfolio that’s seen a lot of appreciation it’s especially desirable not to sell and realize the capital gains on those appreciated positions.
Who Should Avoid Securities Based Lines of Credit?
I think these lines of credits are misused most frequently to fund people’s lifestyle. They often help finance yachts, exotic cars, yachts, lavish trips, etc. That type of lavish overspending is where the idea that this is the rich man’s subprime lending comes from. The lines of credit are used to fund purchases that are beyond someone’s comfortable financial reach.
I think those types of purchases are much better made either via traditional lending routes where someone clearly has the cash flow to fund the purchase or can just make it with cash on hand. While borrowing heavily against your portfolio doesn’t guarantee a bad outcome, it adds the potential to wreak havoc on your financial life.
Wrapping Up
In the end I think there are some legitimate and interesting uses of securities based lines of credit. Like most things, it depends on how it fits into your overall financial picture and your goals. I think it’s probably a more niche product with limited appropriate uses than it’s currently being used for. But when have wall street brokerages ever let that stop them?
Scott Caufield, CFA, CPA