Securities-Based Lending, also called non-purpose lending or securities-based borrowing, has helped investment banks achieve significant growth since the global financial crisis. In fact, securities-based lending balances and accounts have grown since 2011, thanks, in part, to the constant rise in low interest rates and equities. But what exactly is securities-based lending, and why is it popular?
Definition of Securities-Based Lending
Securities-based lending (SBL) is when borrowers and lenders use securities as collateral to make loans. SBL allows borrowers to access capital that they can use for a wide range of purposes, including investing in a business, buying a vehicle or property, and purchasing real estate. However, borrowers cannot use this type of lending to repay a margin loan or buy shares in a company. Securities-based lending is usually offered through private banks, brokerage firms, and large financial institutions. In most cases, it is sought by and available to people with large amounts of capital and wealth who wish to execute significant financial transactions or make large business acquisitions. Borrowers may also use a securities-based loan to buy luxury goods, pay for vacation, or complete tax payments. But while these loans have previously been associated with high net worth individuals, it is today a funding option for borrowers with smaller portfolios.
How Does It Work?
Now that you know what securities-based lending is let’s look at how the process works. Typically, the lender will review the borrower’s investment portfolio to determine the value of the loan. They may also review the underlying asset when establishing eligibility. The lender may even end up approving the borrower for the loan based on Treasury notes instead of stocks. When the loan is approved, the borrower will deposit their collateral – their securities – into an account. The lender then becomes the official lienholder on this account. Should the borrower default, the lender can legally seize the collateral in the account and use it to make up for their losses. The borrower will usually get their loan within a few days of the approval. Generally, the rate charged on the amount will vary depending on the 30-day London InterBank Offered Rate (LIBOR) but often range between 2 and 5 percentage points above LIBOR. Securities-based loans can be delivered as installment loans that must be paid at regular intervals or a line of credit that you can use, pay off, use again, pay off, and so on.
Ways You Can Use Securities-Based Lending
According to Ameriprise, you can – for the most part – use securities-based loans for any purpose. However, many lenders place some restrictions on this general rule. You cannot use an SBL loan to buy more securities – a margin loan may do better in this case although it carries significant risk. You also cannot use this type of funding to repay a margin loan or another loan that you used to purchase securities. That said, if you wish to expand your business or deal with an emergency, or are looking for bridge financing, you can increase your liquidity in the short term effectively through an SBL loan. You can also use securities-based lending for the following:
- To manage capital gains taxes.
- To cover short-term living expenses or small business costs.
- To manage an unexpected emergency.
- For construction bridge financing.
- To purchase real estate.
- For major life expenses like a wedding or school tuition.
- To finance short-term home improvements.
- To purchase a vehicle or property.
Securities-Based Lending Vs. Securities Lending
Investopedia explains that, while they are somewhat similar, securities-based lending is distinct from securities lending. Securities lending refers to the process of loaning your securities to a bank or investment company through derivatives like stocks. On the other hand, securities-based lending involves using these securities as collateral when borrowing. It is usually offered by private banks and large financial institutions. In contrast, securities lending happens between investment dealers or brokers – not individuals. These parties define the nature of the loan, including the collateral, fees, duration, and terms.
Benefits of Securities-Based Lending
When it comes to the borrower, securities-based lending helps this party gain liquidity without having to sell their securities. Selling securities is a taxable event that could disrupt an investor’s investment strategy significantly. SBL loans are also available fast, at lower interest rates, and with more repayment flexibility. Consequently, they are great for short-term financial problems that require cash fast. Securities-based lending is also highly beneficial to the lender. It offers them an added and rich source of income without any additional risk. Since the process involves creating relationships with high-net-worth individuals, the risks associated with traditional loans are effectively mitigated. Securities, which are used as collateral, also have high liquidity. Here is a rundown of these and more benefits:
Fast Processing Times
You can usually get an SBL loan in a few days, which is beneficial if you need cash fast. While you can get funding faster through a credit card or personal loan, these types of loans have higher interest rates than SBL loans.
Low Interest Rates
Typically, securities-based loans are given at lower interest rates than unsecured forms of funding. The rate used is usually variable depending on index rates like the LIBOR but can be 2 to 5 percentage points above this rate.
Flexible Credit Requirements
SBL loans do not involve a credit check so you can get a loan even with poor credit as long as you have invested enough for collateral. This makes SBL a great alternative to other short-term credit options, personal loans, and credit cards.
No Need to Sell
Arguably, the best perk of SBL loans is that you do not need to sell part or all of your portfolio to get cash. Cashing out and the accompanying taxation can leave you in a worse off place than you were before the sale, and these loans prevent that.
Risks of Securities-Based Lending
Under the right circumstances, securities-based lending can present a win-win situation for the lender and borrower. However, its growing popularity and usage has raised concern over the systematic risk it might pose. A 2016 Morgan Stanley report shows that sales of this type of loan rose by 26 percent in 2016 to average $36 billion. Financial experts worry that if the market turns, people could be faced with forced liquidations and fire sales, especially as interest rates continue to rise. Another concern associated with securities-based lending is that it is not tracked by the Financial Industry Regulatory Authority (FINRA) or the Securities and Exchange Commission (SEC). Both bodies warn investors about the risks involved in this type of borrowing from time to time, but there is no oversight. In line with this, here are some potential risks of SBL loans:
In the event, your portfolio falls below a limit set by the lender, you may have to add more funds or securities to your account to meet the set threshold. If you don’t, the lender could sell off some or all of your portfolio, leading to further tax implications.
Restricted Portfolio Access
As mentioned earlier, your securities are transferred into an account for use as collateral when you get an SBL loan. Since the lender is a lienholder on the account, they can restrict your access to some features. You may be unable to move your investment or make withdrawals without permission.
Potential Portfolio Loss
If you default on a securities-based loan or are unable to keep up with payments, the lender can seize your collateral and use it to recoup their losses. Think of it as a mortgage foreclosure or vehicle repossession, only you lose your investment portfolio. When this happens, you may also need to pay taxes for the sale of your securities.
SBL loans are offered at floating interest rates that vary and can change from one month to the next. During periods of low interest rates, this may not be a problem, but the fees can rise significantly if interest rates rise.
When Is Securities-Based Lending Good for You?
Before you use your investment portfolio to apply for a loan, you should weigh all the benefits and potential risks and determine whether a securities-based loan is ideal for you. SBL funding is easier to get, and the interest rates are highly competitive. However, you risk losing part or all of your portfolio if your securities fall below the threshold set by the lender. You can usually minimize this risk by diversifying your portfolio so that it remains stable during the loan repayment period. Additionally, you should consider only putting up a portion of your portfolio as collateral for a securities-based loan. Doing this will minimize your risks even further so that you do not end up losing your entire investment. For instance, if you can borrow up to 80 percent of your account value, consider only taking 40 or 50 percent.
Furthermore, simply because these loans are fast to get and cheap, do not mean you need them. Evaluate the problem you wish to solve and try to determine if you can get the money another way. Regardless of what you are using as security, a loan is a debt, and you should be sure you are willing to take it on and be able to pay it back. If you determine that borrowing is the only viable solution in your situation, consider other funding options that carry less risk. For instance, while unsecured loans often charge more interest, they do not carry any risk of asset liquidation or margin calls. US News also reports that you can avoid paying high interest rates on credit cards if you pay off the balance before the due date.
Alternatives to Securities-Based Lending
Using securities-based lending to fund your venture is a financial decision that you should consider at length. As you do, it is important to review viable alternatives to this form of funding, such as:
Improving Your Credit
If you do not need money immediately, you can take time to improve your credit then apply for a traditional loan. Start by checking your credit report and credit score to understand where you are and what adjustments you need to make to increase your creditworthiness. You will also need to address all the negative credit items on your report.
Selling Your Portfolio
Selling off some of your investments is not the best way to get funding, but it can be a viable option in some cases. This is especially true when you have an undiversified portfolio that could be subject to a margin call. That said, you should remember that selling off your investments will have significant tax implications.
Getting a Personal Loan
If you have good credit, consider getting a personal loan with a relatively low interest rate or a credit card with a 0 percent introductory APR.
Using Your Credit Card
You can also use the credit cards you already have to cover your expenses, especially if they are short-term emergencies. You might be charged a higher interest, but your portfolio will not face any risks.
Asking Friends or Family Members for Help
If you have bad credit and cannot qualify for a traditional loan with a reasonable interest rate, you can ask friends or family for a loan. According to Experian, improving your creditworthiness can take time, but it will be worth the effort. It will mean that you qualify for traditional loans and lower rates and do not need to touch your portfolio. Nonetheless, if you need money fast, securities-based lending remains a viable funding option.
How Does Securities-Based Lending Affect Your Credit?
When you apply for a securities-based loan, the lender may or may not run your credit. They may also fail to report your monthly repayments to credit bureaus, which means securities-backed lending rarely affects your credit. That said, always confirm the terms with your lender before accepting the loan.
You can use securities-based Lending to invest in a business, buy a vehicle or property, or buy real estate. Securities-based loans are usually available to high net worth individuals, but people with smaller portfolios may also qualify in some cases. Remember, when you get this loan, you move your securities to another account over which the lender is a lienholder. Aside from the limited access to your portfolio and risk of margin calls and liquidation, securities-based lending is easy to access, offers more repayment flexibility, and charges lower interests. You also will not need to sell your securities to get capital.
Written by Allen Lee
Read more posts by Allen Lee