Is a Pledged Asset Mortgage Right for You?

by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
February 17, 2005

What is a pledged asset mortgage?
A pledged asset mortgage allows homebuyers to pledge financial assets to a mortgage lender instead of making a down payment. Depending upon the lender, you can pledge almost any type of financial asset, including stocks, bonds, mutual funds and certificates of deposit (CDs), while maintaining ownership. With a pledged asset mortgage, you can enjoy the benefits of making a large down payment—more attractive interest rates, no private mortgage insurance (PMI), and so on—without actually having to come up with the cash.

Who might consider a pledged asset mortgage?
Pledged asset mortgages usually make the most sense for wealthy people who are in high tax brackets and inclined to buy more expensive homes. However, high net worth isn't necessarily a prerequisite. A pledged asset mortgage could also make sense for someone who needs a bridge loan while waiting on the sale of another asset, such as other real estate or a small business.

Other candidates might be parents or grandparents who want to help their children, grandchildren or other relatives buy a home. If they have sufficient investments, they could help family members qualify for better lending terms without making a potentially taxable gift, and without disrupting their investment plan. For example, the Federal National Mortgage Association (better known as Fannie Mae) has a pledged asset mortgage program for families, although you can only pledge CDs.

How does a pledged asset mortgage work?
Instead of making a down payment on a home, you pledge investments, which are transferred to an account maintained by the lender. You're still free to manage the account and make trades (within certain limitations), but you can't make any withdrawals or transfers without the lender's permission. The lender will usually allow you to withdraw amounts in excess of the initial pledge requirement, but don't count on your pledged assets for short-term liquidity.

Ideally, the pledged asset account should be broadly diversified and consist of high-quality securities. Don't let the pledging of assets divert you from your long-range investment goals. True, your pledged assets aren't readily accessible, but they still belong to you and you should manage them as part of your overall investment plan.

In a typical arrangement, you might be required initially to pledge investments worth 130% of the pledged asset portion of the loan (this works out to 39% of the total loan—see the example below). If the value of the pledged asset account later drops below 110% of the pledged asset portion of the loan, you may be required to add more assets to the account to meet the 110% maintenance threshold (similar to a margin call). The lender generally reserves the right to increase these levels depending on the securities you pledge.

A hypothetical example
Bob and Susan want to purchase a $1 million home. With their high income and excellent credit rating, they qualify for 100% financing. But they could get a much better interest rate on the mortgage if they make a cash down payment. Unfortunately, they don't have that kind of cash sitting around.

However, they do have a diversified investment portfolio with a market value of $800,000. Given current market conditions (and factoring in the after-tax cost of mortgage debt), Bob and Susan believe their investments have more potential for appreciation than the home they're looking to buy—in other words, they believe they would suffer an opportunity cost if they cash out some of their investments to make a down payment. They would also like to stay diversified and avoid the capital gains taxes and transaction costs that would result from selling investments.

Assuming Bob and Susan are determined to buy the house, they have three choices:

Seek 100% mortgage financing without pledging assets and pay the higher interest rate.
Cash out enough investments to cover the down payment plus the resulting transaction costs and taxes. Of course, this would significantly diminish their portfolio.
Pledge $390,000 of their investments as collateral for the loan. By pledging a portion of their portfolio, Bob and Susan get a lower mortgage rate, similar to what they would get if they put down cash. They also avoid PMI, maintain their investment plan, and avoid the costs and taxes that would result from an outright sale of their investments.

What are some disadvantages of a pledged asset mortgage?
Here are some potential pitfalls to consider:

A pledged asset account typically has the following limitations:

No margin borrowing on pledged securities.
No options trading.
No day trading.
No check-writing or debit card features.
You can't pledge assets in retirement accounts.

Pledged asset mortgages generally work best when stocks are going up and home values are rising or relatively stable. A bear market in stocks combined with falling home prices is obviously not favorable for this type of loan.
If you default on the mortgage, the lender can tap both your pledged assets and your house to cover the loan.
You may be required to pledge additional assets if the value of your pledged asset account falls below minimum maintenance levels.
The lender is allowed to unilaterally liquidate your pledged assets if you fail to meet a maintenance call.
If you finance 100% of the cost of your new home with a pledged asset mortgage, your overall interest payments will be larger than if you cash out investments and use the money for a down payment. Consult your tax professional about the relative, total, after-tax cost of debt. You should also consider the potential appreciation/depreciation of your pledged assets and your home.

Is a pledged asset mortgage right for me?
There's an old saying that those who don't need to borrow usually get the best terms. A pledged asset mortgage is generally not a viable option for those of limited means. They work best for people who have excellent credit, higher-than-average income and net worth, adequate liquidity and many years of investment experience.

Ultimately, whether a pledged asset mortgage makes sense for you depends on your unique situation. Talk about the pros and cons with your lender, and be sure to enlist the help of your investment advisor and tax professional.

Charles Schwab & Co., Inc. and Charles Schwab Bank are separate but affiliated companies and wholly-owned subsidiaries of The Charles Schwab Corporation. Brokerage products and services are offered by Charles Schwab & Co., Inc., Member SIPC, and are not FDIC insured, are not guaranteed deposits or obligations of Charles Schwab Bank and are subject to investment risk, including possible loss of the principal invested. Deposit and lending products and services are offered by Schwab Bank, Member FDIC and Equal Housing Lender.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

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