Securities based lending has become a booming business on Wall Street in recent years, but before customers enter into these lending arrangements, they need to understand the substantial risks involved, including having to sell all of your stocks and pay back the loan in the event of a market downturn.
Many stockbrokers sell their customers on the idea of securities based lending as a way to borrow money by using the stocks in their account as collateral. Customers are enticed with the low interest rates and the ability to borrow anywhere from 50 to 90% of their portfolio stock value. The only restriction is clients are not permitted to use the borrowed funds to buy more stock like a margin loan.
This sounds all well and good, and many borrowers see securities based lending as a good way to fund cash flow for small business or refinance other debt. But the devil is in the details and unfortunately, many customers don’t appreciate what exactly they are getting themselves into until it is too late. Interest rates on securities-backed loans can change every day. In addition, your brokerage firm may decide that a security that was previously eligible as collateral is no longer available to secure your loan, leaving you with less money to borrow, or even worse, in the position where the loan is called.
Importantly, securities-backed loans are demand loans, meaning that the lender may call the loan at any time. If you can’t repay it, the firm can move in right away and sell securities in your account to pay the balance in full. During volatile markets, the value of your stocks could quickly decline significantly and if you don’t have extra cash on hand, then you might be forced to sell your stocks and pay back the loan immediately. Wall Street likes these loans because it is another way for them to make money off the stock that is sitting in your investment accounts.
Before you agree to a securities based loan, make sure you’ve read the fine print and understand exactly what you’re getting yourself into.