Debt often gets a bad rap. But when managed responsibly, it can help you achieve your financial goals. In fact, the more assets you have, the more lending solutions you may have at your disposal.
"Clients who have built up their net worth—whether in their homes or investment portfolios—could have broader borrowing options by using their own assets as collateral," says Chris Kawashima, a senior research analyst at the Schwab Center for Financial Research. "But doing so exposes those assets to increased risk, so you’ve got to have the fortitude and investment knowledge to manage such debt effectively."
Let's take a look at three asset-backed lending solutions—and under what circumstances they might be most appropriate.
1. Home-equity line of credit
What it is: A home equity line of credit (HELOC) allows you to borrow against the equity in your home. As with a credit card, you draw from and repay an available line of credit, usually at variable interest rates.
Unlike credit cards, HELOCs typically have a fixed draw period (often five to 10 years), after which time the line of credit is closed and any remaining balance must be paid back, with interest, before the repayment period ends (often 10 to 20 years).
When to use it: Although you can use a HELOC for many purposes, it's particularly well-suited to:
- Home improvements: If you itemize your deductions, the IRS may allow you to deduct interest paid if the funds are used to "buy, build, or substantially improve your home." That can make HELOCs an attractive option for financing home improvements.
- Liquidity: Even if you don't have an immediate cash need, establishing a HELOC can be a great way to back up your emergency fund or short-term savings. For example, if you need cash during a market selloff and want to avoid tapping your cash reserves or selling securities at a loss, drawing on a HELOC could offer an alternative source of funds. "Should the markets bounce back, you can replenish what you borrowed," Chris says. "In that way, the loan can act as a nice little safety net."
- Debt consolidation: Interest rates on HELOCs often are much lower than those charged by credit cards and personal loans, making them a potentially attractive option for consolidating debt and reducing borrowing costs. Because a HELOC is secured by your property, however, Chris says you should have a solid payoff strategy before you consolidate higher-interest-rate debt, since you could be putting your home on the line if you can’t pay it back.
P.S. Lenders need time to process a HELOC application because it requires a home appraisal and a review of both your credit and financial histories, which can take weeks. "Because of the time involved, it’s best to open a HELOC well before you need the funds," Chris says.
What it is: Just as a bank can lend you money against the equity in your home, your brokerage firm can lend you money against the value of eligible stocks, bonds, exchange-traded funds, and mutual funds in your portfolio. Margin loans typically require a minimum of $2,000 in cash or marginable securities and generally are limited to 50% of the investments' value. Interest rates vary depending on the amount being borrowed but tend to be lower than unsecured lending options such as credit cards.
When to use it: Funds borrowed on margin are usually used for:
- Additional investments: Active traders may establish a margin account as a way to take advantage of a trading opportunity when they don't have adequate cash on hand. If you use the funds to purchase investments that generate taxable income—including interest, nonqualified dividends, and short-term capital gains—you may be able to deduct the interest paid if you itemize your deductions. However, if the value of your margin account falls below the maintenance requirement—the minimum dollar amount that you must maintain in the margin account once you’ve tapped the funds—your brokerage will issue a maintenance call, which requires you to either deposit more money or marginable securities, or sell some of the assets held in your account.
- Short-term liquidity needs: As with any line of credit, you can draw from and replenish a margin account for any reason, not just purchasing securities. "A margin loan is a ready source of credit that may be used as a short-term loan for any need—and unlike a HELOC, there's no lengthy application process," Chris says. "But I can’t stress enough the importance of moderating your borrowing. If you borrow too much and your portfolio's value declines before you repay the money, you could face a hefty maintenance call—or a large tax bill if appreciated securities are sold to meet the maintenance requirement."
P.S. It's important that the assets in your account are diversified. If you're overly concentrated in a particular investment, you could quickly find yourself below the required maintenance threshold if that investment declines considerably.
3. Securities-based lines of credit
What it is: Like margin, a securities-based line of credit offered through a bank allows you to borrow against the value of your portfolio, usually at variable interest rates. Assets are pledged as collateral and held in a separate brokerage account at a broker-dealer. Unlike margin, these nonpurpose credit lines may not be used to purchase securities or pay down margin loans, nor can the funds be deposited into any brokerage account. Such lines of credit also tend to require more borrowing than a margin account (Schwab Bank’s Pledged Asset Line®, for example, has a minimum line size of $100,000 and an initial minimum advance of $70,000).
When to use it: Because of the large initial advance requirement that may apply, a securities-based line of credit is best for:
- Bridge financing: "We typically see a securities-based line of credit used for something that would otherwise be a short-term loan," Chris says. "For example, clients who wish to buy a new home before they’ve sold their current one have found that this type of credit line can provide a useful bridge between the two transactions."
- Liquidity: When you need quick access to cash but don't want to sell your investments—which can trigger capital gains taxes and upend your investment strategy—a securities-based line of credit could be a solution. "Because of the high initial advance requirement, it's best to establish this type of credit line when you have an immediate cash need, such as a significant tax bill," Chris says. "Once you take the initial advance, however, you can use the credit line for smaller liquidity needs going forward."
P.S. A securities-based line of credit from a bank is subject to a high degree of risk, which you should be sure you understand before applying. Should the market value of the pledged collateral decrease, the bank may demand immediate repayment of outstanding obligations or require you to deposit additional cash or securities to the pledged brokerage account in order to avoid the sale of pledged assets. Pledging diversified assets can help reduce this risk. Be that as it may, you should keep an eye on the value of your pledged assets—and have a backup source of funds in the event of a demand.
Have an endgame
Margin and bank-offered securities-based lines of credit, in particular, are best suited for those savvy about the markets. "You need to know how much risk you're taking on—and be vigilant about managing that risk," Chris says.
What’s more, "it’s crucial to develop a repayment strategy, because unlike, say, a traditional mortgage, asset-backed loans generally have a more flexible repayment schedule," Chris adds. "And whatever you do, always pay more than just the interest due each month."
Asset-backed borrowing at a glance
- Home equity line of credit
- Margin loan
- Bank-issued securities-based line of credit
Assets used as collateral>Home equity line of creditReal estate, including your primary residence and second home>Margin loanEligible securities in most nonretirement accounts>Bank-issued securities-based line of creditEligible securities, as determined by the bank, held in a separate pledged brokerage account>
Minimum collateral requirement>Home equity line of creditEstablished by the lender and typically based on the requested line amount and the associated home value>Margin loanTypically $2,000; some brokers may require more>Bank-issued securities-based line of creditVaries; many lenders, including Schwab Bank, require a $100,000 or more minimum loan value of collateral>
Borrowing limits>Home equity line of creditVaries by lender. Check with your financial consultant for details>Margin loanTypically 50% of the assets’ value>Bank-issued securities-based line of creditBased on the loan value of eligible pledged securities, which is typically up to 70% of their current market value; bank may require a large initial advance>
Maintenance requirements>Home equity line of creditN/A>Margin loanTypically 30% of the assets’ market value (below which you may face a maintenance call)>Bank-issued securities-based line of creditVaries; Schwab Bank requires the collateral to have a loan value equal to or exceeding the greater of $100,000 or the amount of the outstanding loans (below which you may face a demand for repayment)>
Term>Home equity line of creditTypically a revolving line of credit until the draw period ends, followed by a repayment period>Margin loanRevolving line of credit, meaning no set draw or repayment periods>Bank-issued securities-based line of creditTypically a revolving line of credit. Schwab Bank's Pledged Asset Line remains in effect, absent a demand or termination, with no stated maturity date. It is payable immediately upon demand by Schwab Bank>
Approved uses>Home equity line of creditAcceptable for most purposes, but check with your financial consultant>Margin loanAny purpose>Bank-issued securities-based line of creditMost lawful purposes other than securities purchases or margin repayment>
Ideal uses>Home equity line of credit✔️ Debt consolidation>✔️ Home improvements✔️ Short- or long-term liquidity needsMargin loan✔️ Stock purchases>✔️ Short-term liquidity needs❌ Long-term liquidity needsBank-issued securities-based line of credit✔️ Bridge financing>
✔️ Short- or long-term liquidity needs
❌ Small initial borrowing need