One of the best and worst developments of the last ten years is the increasing availability of investment opportunities and investment advice to the general public. Services that didn't exist when I started in the industry, like WeBull and Robinhood, allow lay persons to learn about investments and buy and sell stocks and index funds without paying a commission to a human broker. Robo-advisors like Wealthfront and Betterment offer automated investment management for those who don't want to make their own investment decisions, often at less than half the price of a human advisor. These platforms have even opened the door for investors hoping to borrow money in hopes of buying more investments. And that's where the problem lies.
It's inevitable that over the past couple years, you've run into people (likely with no training or certifications to give investment advice) telling you how the best way to make money is by *insert hot topic of the day here*. One of those topics du jour has been options trading, a potentially wonderful tool for those who are financially established enough to do it and learn how it works. Another has been things like meme stocks. And for both topics, it's not uncommon for people to use something called margin trading to purchase more investments than their actual money allows. And this is where the bad comes in, because borrowing money you don't have to buy an investment you might not understand is, to me, one of the worst possible decisions you could make.
There is, however, a form of financing you can secure based on money you DO have. It's called a Securities Backed Line of Credit, or an SBLOC (Some also call it a Portfolio Line of Credit). SBLOCs are a form of securities-based lending; and while it does have its risks, it works much differently than trading on margin.
You will find that most brokerage companies will offer SBLOCs to account holders whose investment balance meets a certain threshold. In fact, some of the robo-advisors we discussed will open one for you automatically once you reach the threshold.
Let's look at how at the pros and cons of an SBLOC, how it compares to margin trading, and how to know if it's right for you. And we'll start by explaining the concept of collateral.
Collateral/Hold My Watch
To understand SBLOCs, you first have to understand the concepts of collateral and margin.
If you borrow money from someone or some company, in most cases, they will want to hold on to something of a value that is, at minimum, equal to what you've borrowed. Whatever they choose to hold onto, be it a house, a car, is the collateral. You have "pledged" it to your lender as good faith that you will repay the debt, and if you don't, they keep the collateral.
Let's look at a scenario of a person who needs to borrow $20,000 from a friend.
The friend needs assurances that they will be ok if for some reason you can't give them back what they loaned, so they ask to hold onto your watch that is worth ... $20,000. As long as they have the watch, they are less worried about the money they loaned to you, because if you don't pay them back, they can sell the watch and get their $20,000 back.
It's worth noting that a watch is an asset that in many cases will appreciate in value over time, or at minimum, its value will be static. The likely increase in value reduces your friend's risk that you don't pay them back and they're left with a watch less than what they loaned to you.
But not all assets used as collateral will increase in value, and some even decrease. The greater the risk of the collateral decreasing in value, the more of a buffer - or margin - the lender will want between the value of the collateral and what they offer as a loan.
Now let's assume we have a friend who is willing to lend you money, and you offer baseball cards as collateral. The cards are currently worth $20,000, but you and your friend know that the value of a collectible can change drastically over the years. Let's look at how they protect themselves:
Even though the cards are currently worth $20,000, your friend decides they want to protect themselves in case of a drop in value. They tell you that they will loan you 75% of the cards' value, or $15,0000. Now if the value decreases slightly, they are still holding collateral worth more than the outstanding loan. In investment terminology, the remaining 25% buffer between the loan and the cards' value is called the margin.
If we extend this scenario a little further, what do you think would happen if you came and decided to take some of those cards you gave them as collateral, thus reducing the value of collateral? They would tell you to either pay them back some of the money you borrowed, or give them more cards.
Is This The Same As Margin Trading?
Not at all. It was important to give this background because there is a large difference between margin trading, and how collateral is used to offer an SBLOC.
In margin trading, people who have taxable brokerage accounts can borrow money from the brokerage company and use it to buy securities.
For example, if an account owner has $5,000 in their account and wants to buy 75 shares of an investment currently trading at $100, they would be $2,500 short (meaning they can only get 50 shares). They can take a margin loan from the brokerage for $2,500 and use the money to buy the additional 25 shares.
Should those 75 shares, worth $100 at purchase, increase in value to $150, the account owner can sell approximately 17 shares to repay their $2,500 margin loan and pocket the rest of the profits.
But if the share value crashes to $20, the 75 shares - and their entire account balance - are worth $1,500. And guess how much they still owe on their loan? $2,500.
With margin trading, it IS possible to lose more than the value of your initial investment. The investor/borrower is using the leverage of the margin loan to buy more shares of an investment than their money allows. With the trading cards, as long as your friend has the cards worth $20,000 as collateral, they're less worried about the loan. And as the borrower, you're (slightly) less worried about the loan as well, because if you don't make payments or come within their allowable margin, they'll simply keep some of the collateral for good or ask you to give them more. Your potential losses are built into the transaction. But with a margin loan, there is not a mechanism for the lender to limit your losses like our example with the trading cards. Margin trading losses are potentially unlimited, which is why I'm clearly going to painstaking lengths to differentiate between margin trading, and the margin lending found in Securities Backed Lines of Credit.
So How Do SBLOCs Work?
Make sure you understand the trading card scenario. Substitute the trading cards for a taxable investment account, and you pretty much have SBLOCs down pat.
Unlike margin trading, where you essentially take a loan from the brokerage company and use it to buy securities in that same brokerage account, Securities Backed Lines of Credit utilize money you already have to provide access to funds that will be used to buy something OUTSIDE the brokerage account. As a matter of fact, owners of Securities Backed Lines are prohibited from using the funds to buy securities that will be placed in the brokerage account.
Let's look at an example of an account owner with a $100,000 investment balance and access to a $50,000 SBLOC:
Even though our owner borrows $35,000 on the line of credit collateralized by their $100,000 investment account, they still have their full $100,000.
Now let's get to the meat and potatoes of SBLOCs.
How Much Can I Borrow?
The amount offered to you on your line of credit is often impacted by the level of aggression found in the securities being used as collateral. More aggressive investments typically mean more volatile investments. Huge swings up or down in the value of a portfolio being used as a collateral increase the risks that your investment balance might fall below the minimum margin requirements set by the lender.
As an example, if a lender requires a minimum margin of 40% between the balance of the collateralized investment account and the amount borrowed on a line of credit, a lender would not allow a person with a $100,000 investment balance to exceed a balance of $60,000 on any SBLOC.
If the $100,000 is invested conservatively, and odds of a down market bringing their investment account below $95,000 or $90,000 are low, the lender might be comfortable extending them a line of credit of, say, $50,000; 50% of their current $100,000 balance, which means a potential margin of 50% if the line were to be maxed out (remember that the margin is based on the amount actually borrowed, not the amount you could borrow). They might be comfortable getting so close to their 60% line in the sand because with a conservative investment they feel would be unlikely to fall $90,000, a typical market loss would keep the borrower within the margin requirements even if they were to max out their line of credit ($50,000 funds borrowed/$90,000 account balance = 56% margin). Now a problem can occur if there are extreme market losses, or if the account owner withdraws some of the securities pledged as collateral, the consequences of which we'll cover later in this post.
If the holder of our investment account invests their funds extremely aggressively, and a 15% to 20% loss - which would bring their account balance down to as low as $80,000 - would not be unusual, they will be offered a lower line of credit. Why? Because the likelihood that a market loss brings the borrower over the allowable margin requirement has increased. Should the lender offer them the same $50,000 line and they max it out, a market loss bringing the pledged investment account down to $80,000 would mean a margin of 63%. To prevent this scenario, the lender will be more conservative when lending based on aggressive investments, and likely reduce the amount offered to the borrower as a line of credit.
Why Do People Like SBLOCs?
Securities Backed Lines of Credit are a flexible funding source, or option for debt refinancing, for several reasons.
They Don't Always Impact Credit Utilization
We've covered FICO credit scores in detail in the past, and shared that 30% of your score is your Credit Utilization . Credit Utilization is a reflection of the percentage of available revolving credit you've borrowed at a given point in time. Examples of revolving credit or things like credit cards or Home Equity Lines of Credit. Credit cards are typically the main form of revolving debt reflected in credit utilization, but HELOCs and SBLOCs do not show up on most scores. Why? Since you've pledged either your home or an investment account as collateral, these forms of debt are considered secured debt: the lender can seize your property if you don't repay. As such, you can open up and utilize these lines of credit without worrying about damaging credit utilization - the second largest part of your score - because of how much you borrow.
Approval Is Fast
If you think about it, this should make perfect sense. The risk to the lender that you default is pretty small, seeing as they get to keep your investment account if you do. Because of the decreased risk, approval for an SBLOC can often be granted in a week or two. Compare that to a HELOC, which can take a couple months, or a small business loan, which can take 3-4 months, or a mortgage, which can take the same depending on your finances, and you'll see there aren't many forms of financing that can be secured as quickly as an SBLOC
You Have Fast Access To Non-Taxable Funds
Any money you borrow from an SBLOC is a loan, it's not actually your money. And you don't pay taxes on a loan. You DO, however, pay taxes when you sell securities for a profit, and you also lose the benefit of keeping those funds invested to (hopefully) grow some more. By using an SBLOC, you can move quickly when you need to deploy resources, without having to wait for a trade of securities, or worry about the taxes that would result from the sale.
Payments Are Interest Only ...
A huge draw of HELOCs and SBLOCs, which can lead to real danger if you aren't disciplined to pay down the principal, is that you're not REQUIRED to pay down the principal. These lines of credit often only require the interest on any funds you actually borrowed to be paid on a monthly basis. For example, if you borrowed $10,000 from a line of credit at 6% interest, $50 month ($600 of yearly interest/12 months) would be all that's required as payment.
... And Can Stay That Way Forever
I know this sounds nuts, but it's true. As long as you have maintained the margin required by the lender, SBLOCs do not expire. In the scenario above, you can keep paying $50/month and continue to owe $10,000 as long as your investment account stays open and within the margin requirements. This feature puts the borrower in more control of how they repay debt, or how they fund a potential investment.
What Are Some Uses of SBLOCs?
There are no restrictions on how SBLOCs can be used. Their interest rates are often more competitive than what you'd find for a car loan, or credit cards, and it's easier to set them up than mortgages, or HELOCs, or small business loans. So it's not uncommon to see people with smaller lines of credit use them instead of a credit card, or to buy a car rather than using an auto loan, invest in a business, make a down payment on an investment property, etc.. And in the case of larger lines of credit, account holders will even use them to buy an entire home in cash and place a traditional mortgage on the property after the fact. We'll cover how this is done in a future post.
What Are Some Cons to SBLOCs?
It's not all peaches and cream. There are downsides to an SBLOC if you're not careful.
Securities can be seized to cover defaulted loans
We covered this with the watch scenario (yes, there's a reason I started with the watch). If you don't pay back your SBLOC and default on the loan, the lender can take your "watch" (the investment account)!
Margin requirements can necessitate a liquidation or a cash influx
We covered THIS with the baseball cards scenario (yes, there's a reason I started with THAT too). If you don't have enough margin between your collateral and what you owe, you must either put enough money in the account to reestablish the margin, or you have to start actually paying back what you owe. If you don't make a lump sum payment, the lender will do it for you by forcibly trading enough of the investments in your portfolio to pay themselves back.
Securities can't always be removed from the pledged account
Again, you must maintain the margin. If you plan to borrow a ton of money on the SBLOC, the benefit is you get to keep your investment account invested. The negative is those funds must remain in the account! You can't move them elsewhere without repaying the loan or a portion of the loan.
Payments Are Interest Only ...
Yes, I'm aware I also listed this as a pro. But in reality, any time you take on a debt that doesn't require you to pay the principal each month, you run the risk of borrowing money recklessly. By lessening the sting of repaying the debt, it's easy to borrow more than you need, or borrow without assessing the potential return of what you're using the money for. You must approach the decision to borrow from your SBLOC with the same process you use to assess debts that carry a higher repayment.
SBLOCS can be a complicated concept if you're not familiar with the basics of collateral, but I hope this post has helped break down the foundational principles. Stay tuned for a future post where we show you how people can use SBLOCs to gain a competitive advantage in the home buying process!
*This material is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security or lending strategy. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult your financial advisor for further information. The views expressed are not necessarily the opinion of Royal Alliance Associates Inc.