Before you use your assets as collateral for an SBLOC, take time to understand the risks, and get answers to important questions about how this type of lending arrangement could impact your long-term investment goals.
- When I take out an SBLOC, what am I agreeing to? Make sure you fully understand the details of any SBLOC offered to you, including the terms of your agreement with the lender and how the lending arrangement will impact your holdings, including potential tax consequences, maintenance call requirements, and other costs. You need to know what aspects of the arrangement are out of your control. For example, the interest that you pay on your loan may change every day. In addition, your firm may decide that a security that was previously eligible as collateral for an SBLOC is no longer eligible. If this happens, your credit limit will be adjusted to reflect the change, leaving you with less money to borrow than you planned for. You also may be required to post additional assets to shore up the account if the remaining eligible securities cannot cover the balance. In addition, some SBLOC agreements permit the lender to increase the percentage of equity you must keep in your pledged accounts, which would require you to deposit additional securities or cash into the account, or pay down the loan.
- Who is the lender? Before you sign up for an SBLOC, understand who you are doing business with (your brokerage or advisory firm, one of its affiliates, a clearing firm or a third-party lending institution). Many brokerage firms offering SBLOCs do so through a bank affiliate, so your broker may not be the point of contact for your loan and may not know much about how the program works. Make sure you know who to contact with questions about the SBLOC and ongoing account services. If your securities firm is offering the SBLOC for a third-party lending institution, ask your firm how they will continue monitoring your account and how, and when, you will be notified if a collateral shortfall or other issue may impact your assets.
- Should I use my investments as collateral? While SBLOCs’ low rates and quick access to cash may be appealing, remember that your investment portfolio may not be the best option for loan collateral. The prices of securities in your portfolio are constantly shifting, which means that the collateral backing your line of credit may be volatile. If the market is up and the value of your assets increases, then great. But nothing guarantees that the market, or the value of your assets, won’t go down.
- What if the value of my portfolio decreases? The firm might sell your securities if you receive a maintenance call and are unable to meet it. SBLOCs seem like a great option for extra capital when markets are producing positive returns and interest rates are low, but a market downswing or change in interest rates could make it much less enticing, and this can happen at any time. The value of your holdings is always changing, so you can’t assume that the price today will be the price tomorrow. And keep in mind that SBLOCs are classified as demand loans, which means lenders may call the loan at any time.
- Does my investment mix matter? Consider the extent to which your portfolio is diversified. If your portfolio is concentrated in a particular stock or sector, a single market event could cause your portfolio value to drop precipitously and trigger a maintenance call. Then you might be forced to liquidate your assets at the bottom of the market. Other assets may be more appropriate to serve as collateral for a loan, and without terms that allow the lender to liquidate your investments at a moment’s notice. With that in mind, if you do decide to pursue an SBLOC, consider taking out less than the maximum amount of credit offered to you.
- What if my securities are liquidated to meet collateral requirements? There might be tax consequences. For example, if your lending firm notifies you that securities will be liquidated to maintain collateral at a sufficient level to support your SBLOC, you could be faced with paying capital gains taxes on the proceeds from these sales, depending on your cost basis in the stock and other factors affecting your tax status. Lenders often are permitted to make these decisions without giving you any notice. One way to protect yourself and your assets is to limit the amount you borrow. If you are offered an SBLOC based on a high percentage of the value of your assets, consider taking a lesser amount than what you are offered, so that you are not putting such a substantial portion of your portfolio on the line.
- What impact will an SBLOC have on my pledged investments? If you pledge securities that typically receive dividend payments, you should determine whether those payments will be credited to your loan balance and what, if any, circumstances will cause ownership of your holdings to change. In addition, certain account features may change with securities pledged for an SBLOC, such as check-writing privileges and recurring distributions. Some firms cancel check-writing privileges for your account when you take out an SBLOC because you will be issued a new set of checks directly tied to the SBLOC.
- What about interest rates? If interest rates rise, it could cause a spike in the broker-call, prime or LIBOR rates that apply to your SBLOC. If this happens, the cost of your SBLOC may increase significantly. Also, for accounts that have money market funds or bank sweeps, depending on your firm’s SBLOC policy, the debit in your account from the interest charge may be paid from redemptions, effectively reducing your cash or money fund balances. Interest payments may be rolled into the balance, which, over time, can erode the value of your account (particularly if the SBLOC is sizeable), or increase your indebtedness. In addition, depending on the interest rate environment, if you have a money market fund or cash in your account, you may be paying more in interest for your SBLOC than you are earning.
- How is my broker compensated with SBLOCs? Your broker or adviser may receive additional compensation or a portion of the fees generated by SBLOCs sold to customers. Some firms pay salespersons on a quarterly basis depending on how much money you have borrowed on the line of credit. Your broker or adviser also will benefit from your SBLOC because you don’t have to liquidate assets in your account to pay for things with cash, which would diminish the assets held in the account and the potential fees and commissions that could be earned by your broker or adviser from holding or engaging in future transactions with those assets. For example, with a fee-based account, by encouraging investors to take out an SBLOC to fund some purchase or financial need rather than liquidate securities, the firm continues to earn fees on the full account value, and may also earn revenue from the new loans.
- Can I move to a new firm if I have an SBLOC? It is not as easy to pick up and move your assets to a new firm if they are pledged as collateral for an SBLOC. This makes an SBLOC a “sticky” product because it makes it more difficult to leave your current brokerage or advisory firm. To move, you will likely have to pay off the loan.
The foregoing information is being provided by The White Law Group.
The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Franklin, Tennessee. The firm represents investors throughout the country in FINRA arbitration claims against their financial advisor.
For more information on The White Law Group, visit www.WhiteSecurtiesLaw.com.