If you don’t understand what you're signing up for with a securities-based loan, you’d be risking your hard-earned savings and possibly facing significant losses. Image Credit: Shutterstock

Dubai: If you have your savings parked in stocks, bonds, or other financial assets, it’s very likely your investment bank or brokerage firm may have offered you a securities-based loan.

When you are offered a securities-backed loan, you are essentially borrowing money while using stocks, bonds or any other assets that are held in your investment accounts as collateral.

“Generally, securities-backed loans are made available by the larger banks and financial institutions, brokerages or advisory firms,” explained Mirin Raul, a debt advisor based in Dubai.

“As it’s a short-term lending option, securities-backed loans can last anything from a few days or weeks to around three years at maximum, although twelve to twenty-four months is more typical.”

If you don’t understand what you're signing up for with a securities-based loan, you’d be risking your hard-earned savings and possibly facing significant losses.

Uses and who can apply for them

“Securities-based lending provides capital to help people buy real estate, to purchase personal property, or to invest in a business,” added Raul.

“These kinds of loans are generally offered to individuals who have a significant degree of capital by large financial institutions and private banks.” But how does it work? Here’s how.

Banks or brokers determine the value of the loan based on the borrower's investment portfolio, and sometimes the issuer of the loan may determine eligibility based on the underlying investment.

Once approved, the collateral, i.e. the borrower's assets, are deposited into an account. If the borrower defaults, the lender can seize the securities and sell them to recoup their losses.

Here’s an illustration of security-based lending
Let's say Mahmood wants to buy a property worth Dh500,000, and when first reaching out to his bank for a loan, the annual interest rate was quoted at 5 per cent. However, assuming he has a stock portfolio of blue-chip companies worth Dh1 million, he can pledge those securities against the loan and will be eligible for a better interest rate of about 3 per cent. Raul explains why this is the case.

“The lender sees the pledged securities as another layer of protection and thus offers a much lower interest rate for that protection. The borrower likes this scenario because the stock portfolio allows them to borrow at a lower rate while keeping the stocks invested. The investor also receives the loan quicker than they would have with a standard loan.”

How soon can such a loan get approved?

“Securities-based lending has multiple advantages for investors looking to access quick cash as in most cases, borrowers can get cash within just a few days,” noted Dubai-based wealth advisor Mohammad Shaan.

“It's also relatively cheap i.e. lower cost, meaning the setup is cost-effective with no setup fees and only the funds incur an interest charge, which is often lower than other lending options, such as refinancing a home and credit card.”

However, Shaan and Raul both cautioned that while securities-based lending can benefit both borrowers and lenders, it’s not always the case. Here’s why.

Globally, as interest rates continue to increase, it is becoming an increasing concern that there could be forced liquidations when the market turns, particularly as usage continues to spike.

How is securities-based lending different from securities lending?
Although securities-based lending and securities lending don’t seem all that different, the latter normally doesn't involve individual investors as it loans securities to an investment company or bank.

Moreover, securities lending takes place between investment brokers who complete an agreement that outlines the nature of the loan—the terms, duration, fees, and collateral.

On the other hand, securities-based lending involves using stocks, bonds, or other assets as collateral for a loan and this kind of lending requires collateral in the form of cash in exchange for the asset.

Risks of investment-based borrowing (leverage)

With the use of leverage, which is simply the borrowed against any investment, as with any investment you need to be very cautious of the fact that losses will be amplified if there is negative performance of the asset. Furthermore, the loan will still need to be repaid.

Leverage is especially risky as losses can occur when the value of an investment fails to rise above the cost to borrow the money. For example, if you borrow Dh12,000 either to buy an asset or take loan against the asset, but its value only rises by Dh10,000, purchasing it cost you Dh2,000.

So, a fall in the value of your portfolio may result in a situation where the value of your collateral no longer covers the outstanding loan. For instance, an increase in interest rates can impact your portfolio’s return – which, again, must be higher than your financing cost to create a positive return.

In other words, using leverage can sometimes result in losses greater than your initial investment. On top of that, brokers and contract traders will charge fees, premiums, and margin rates. Even if you lose on your trade, you'll still be on the hook for extra charges.

Key takeaways

“If you liquidate your investments prematurely, you may compromise on your long-term goals,” added Shaan. “This is why it’s recommended that you borrow funds (against your assets) to preserve the same assets and take advantage of opportunities to grow your investments.

“So rather than tap into your existing investment portfolio, you can use credit as a valuable funding tool. However, financial planners reiterate that any kind of borrowing is not without its key risk of snowballing debt.”

Securities-based financing can be approved against a variety of assets. You can borrow against them up to a certain percentage of their market value. The loan you’re given will depend on the type, currency, quality, volatility, and liquidity of the investment, as well as your portfolio’s diversification.

Can any asset be pledged for securities-backed lending? “In theory, you can use any financial asset as collateral for securities-backed lending,” added Shaan. “However, the more liquid and mainstream your financial assets are, the more options and lenders will be available to you.”