Securities-based lending is a viable alternative to margin loans that investors and business owners can use to finance their ventures. When it comes to business loans, margin loans are the first products that most entrepreneurs consider, and that has been the case for a long time.
However, in recent years, banks and large wealth managers have been experiencing an increase in the value of securities-based lending. Also called non-purpose or securities borrowing, this type of loan offers the benefit of lower interest rates compared to most commercial loans.
Even though an investor may not qualify for the product at present, it helps to understand the basics of security-based borrowing in case the need ever arises.
How a Securities-Based Loan Works
With security-backed lending, a portfolio is used as collateral for a loan. The portfolio must contain assets like stocks, bonds, or treasury bills that can stand as legitimate security. A lien is put on these securities when the borrower deposits them into an account that the lender has access to.
The lender then gives the borrower a percentage of the market value of the securities to use as a line of credit. Usually, this can be anywhere between 30% and 95%. The safety and quality of the assets in a portfolio are the biggest determinants of how much a financial institution can lend. U.S Treasury notes, for example, can garner an advance rate of about 95% while stocks can bring in 50%.
This kind of lending is also called an asset line of credit because the borrower can write a check against the portfolio any time he or she wants a loan. The proceeds from this type of financing can be used to finance anything from real estate to jewelry.
An entrepreneur can use the funds in place of a commercial hard money loan to act as capital. The duration of a securities-based loan can be as long as five years, depending on the agreement, but in most contracts, the maturity term is one year. It means the borrower has to pay it off or roll it over.
The Appeal of Security-Backed Lending
Enterprises have various options when it comes to borrowing ranging from traditional business loans to bridge loans. Securities-based lending presents a different way to secure funding without having to sell assets.
If an investor chooses to sell his or her securities to raise capital, it would mean incurring tax for that event. In this case, the securities only have a lien on them, which the borrower is given flexible repayment conditions to clear.
The low-interest rates of securities-based borrowing is another reason it is preferable for an entrepreneur. Wealth managers look at the credit capacity of the borrower when calculating the interest. The bigger it is, the lower the rates. An investor can even find a private lender willing to give just over 2% interest when other products require 6-8% as interest.
In other cases, a lender may offer to lower the borrowing rates even further by applying a special lien called “abundance of caution” on a real estate asset. Some large banks let borrowers of securities-based loans pay off the interest only, which is deducted automatically from an account.
Because underwriting a securities-based loan is dependent on the collateral value, the process is usually less complicated than other types of larger loans like residential hard money or mortgages. The requirements for borrowers are not very strict, which means these loans are available for different types of businesses, including mergers & acquisitions.
They can also help with hard-to-fund projects like renewable energy. Borrowers only have to work on strengthening the value of their securities.
As the borrower continues to withdraw funds against a pledged line of credit, the borrowing capacity shifts with the evolving value of the securities. However, this mode of lending allows the borrower to top up the collateral by depositing more assets or money into the collateralized account.
Entrepreneurs who are thinking about turning to securities-based lending should not neglect the volatility of stocks and other assets whose values fluctuate with market conditions. In instances where the market crashes and lowers collateral value, the lender has to liquidate the securities. Investors should also know that the proceeds from securities-based lending cannot be used to buy other securities or pay off a margin loan.
Security-backed lending offers a lot of flexibility in terms of negotiating interest rates and repayment conditions. Compared to other types of commercial loans, an asset line of credit is suitable for WTE financing and other projects where banks are hesitant to provide funds.