The Ins and Out of Securities-Backed Borrowing

My wife and I are embarking on a major kitchen remodel, which we plan to pay for with my annual end-of-year bonus. However, the first contractor bill is due beforehand, and we would prefer not to sell any investments to pay it. What's the best option for bridge financing?

What an exciting project! Renovations are a great way to get more enjoyment and satisfaction out of your home, to say nothing of the value they can add—though they can also be quite costly.

Like you, many people decide to pay for major improvements with borrowed funds that they'll repay with a windfall such as a bonus or the sale of other assets. Home equity lines of credit (HELOCs) are a popular option for this type of bridge financing, but if you have a nonretirement investment portfolio, you might also consider a lesser known alternative: a securities-based line of credit (SBLOC).

These credit lines are backed by the value of your nonretirement investment portfolio and can be used for nearly any purpose except purchasing additional securities or paying down a margin loan. They can provide a quick infusion of cash when you need it, both now and in the future, and their interest rates can sometimes be lower than other financing options, such as personal loans or credit cards.

Like any form of borrowing, though, it's important to understand how an SBLOC works so you can weigh its potential benefits against its risks. Here, I'll break down the details to help you decide if this borrowing solution is right for you.

Opening an SBLOC tends to be fast and simple. Unlike a HELOC—which typically requires a home appraisal, multiple months' financial statements, proof of income, and an underwriting process that can take weeks—an SBLOC has fewer hoops to jump through.

The primary factor of your eligibility is the value of your collateral investments, called the initial lending value (ILV), which the lender determines based on the diversification, liquidity, and overall risk within your portfolio. In general, the more volatile or concentrated your holdings, the higher the risk and therefore the lower the ILV; the more stable or diversified your holdings, the lower the risk and therefore the higher the ILV.

Most lenders require a minimum collateral value to open an SBLOC and have a requisite initial withdrawal. However, you'll pay interest only on your outstanding balance, not the entire ILV amount, and you can repay the principal at any time without penalty.

The interest rate you pay will vary from month to month based on a variable short-term index plus a fixed percentage "spread" that is set when your SBLOC is established. For example, if the short-term index is currently at 5.5% and your spread is 2.5%, your variable rate is 8%.

With an SBLOC, even though your assets are being held as collateral, they remain fully invested, allowing you to maintain your current investment strategy and continue to receive dividends and interest payments. In fact, you can buy and sell securities within the collateral account just as you would your standard portfolio—but be mindful of the possibility of a maintenance call should your collateral fall below specified levels.

Despite their attractive attributes, SBLOCs have unique risks that you should carefully consider before you move forward:

If you have an outstanding balance and a market downturn or other negative event erodes the value of your collateral, you could face a maintenance call—which would require you to immediately pay down part of your outstanding balance or pledge additional securities. If you're unable to do so in a timely manner, the lender may sell some of the securities in your collateral account, which could trigger unexpected tax consequences and upend your investment strategy.

For these reasons, I can't stress enough how important it is to understand what the "specified levels" are and to keep your outstanding balance as low as possible, so you're never caught off guard by a maintenance call.

Interest begins to accrue as soon as you borrow money from an SBLOC. As with any variable-rate loan, high or rising interest rates mean higher borrowing costs. We've probably seen the last rate hike of the current interest rate cycle, but it may be some time before rates come down significantly. Be sure to weigh the possibility of today's rates lasting for the foreseeable future—and understand what your borrowing costs will be as a result. For example, will you be able to cover the monthly interest payments if, despite your best-laid plans, you're unable to pay off the balance as originally intended?

Credit lines have no set term, meaning you draw funds as needed and repay them at any time. However, that also means you are required to make only interest payments each month and do not benefit from a fixed payment plan to help pay down the principal. There may also be a minimum initial loan amount.

That's why it's important to approach any outstanding balances with the same rigor you would your other financial goals: create a plan, track your progress, and adjust as needed.

For the right borrower, an SBLOC may be a solution to satisfy short-term cash needs. Just be sure to consider the best- and worst-case scenarios for your plan and talk with your advisor about the costs and risks vis-à-vis your overall financial picture.

Here's to many happy years (and meals) in your new kitchen!