Pledged-asset loans: An innovative approach to home financingJoseph Badalpledged-asset loan, Thornburg Mortgage, PMI
When it comes to financing a home, borrowers often liquidate
personal investments to come up with a downpayment. The problem
with this strategy is twofold. First, liquidating marketable
securities can carry with it the penalty of paying capital gains
taxes on any appreciation of those securities, and second,
liquidated securities are no longer working for the
investor/borrower. While liquidating assets from an investment
portfolio is an option in coming up with a down payment on a
residential real estate acquisition, it is often not necessarily
wise, nor is it always necessary. Today, there are mortgage lenders
who offer a mortgage financing product known as a pledged-asset
loan, which may be ideal for these borrowers.
Basically, a pledged-asset loan is a loan product in which a
mortgage lender allows a homeowner to pledge eligible securities
instead of making a cash down payment. In short, after qualifying
for the loan, homeowners can finance up to 100 percent of the
purchase price of their homes or even acquire a cash-out refinance
up to 100 percent of the appraised value of their properties
without liquidating their investment assets. There are four main
reasons that many homeowners have found pledged-asset loans to be
more attractive than making down payments. They include the
following.
1. Avoiding the capital gains tax that would come from
selling marketable securities
As anyone with an investment portfolio knows, paying a capital
gains taxeven at the long-term rate of 15 percentcan be costly and
painful. And, of course, the tax liability can be significantly
greater in the case of short-term gains in an investment portfolio.
For borrowers seeking to finance a home without paying Uncle Sam
any more than is necessary, the pledged-asset loan can be a
particularly wise financing choice.
2. An investment portfolio that continues to appreciate
and provide income
Theres a popular tale that Einstein was once asked what the most
powerful force in the universe was, and his reply, which probably
came as no shock to financial planners, was compounding interest.
Like Einstein, savvy investors know that there is an opportunity
cost to liquidating assets too early. Funds withdrawn from a
securities account are, by definition, no longer at play in the
market. In a bull market, these opportunity costs can be huge. A
pledged-asset loan is often the most sensible choice for borrowers
whod like to finance a home while keeping their investment accounts
growing.
3. No requirement for private mortgage
insurance
Private mortgage insurance (PMI) is required on mortgage loans
where the loan-to-value (loan amount divided by the propertys
value) exceeds 80 percent. PMI is expensive, but with a
pledged-asset loan, its not needed. Borrowers can pledge securities
to reduce their effective loan-to-value to a percentage below 80
percent and eliminate the need for PMI.
4. Higher deductible interest payments at tax
time
Its hard to believe, but mortgage interest is one of the last tax
deductions available to the average American. Up to a point, the
more interest a homeowner pays on his mortgage, the greater the
annual interest deduction he can make come tax time. By using the
pledged-asset loan product, homeowners maximize their interest
costs and thereby get the greatest tax benefit. How
pledged-asset loans work
With a pledged-asset loan, homeowners can typically pledge their
marketable stocks, bonds, mutual funds, money market accounts
and/or certificates of deposit (CDs). However, retirement accounts
are not eligible.
Once the borrower and lender agree on the securities to be
pledged, the borrower puts his assets into a margin account with a
brokerage firm. Some lenders also allow homeowners to trade inside
their pledged accounts as long as the borrower maintains the
minimum balance required. The value of this account must be equal
to the required down payment, plus a margintypically 130-150
percent of the base pledge amountto protect against changes in the
market value of the pledged securities. However, the margin may be
increased or decreased based on the type of assets a borrower
pledges. For example, a lender may not require a margin at all if a
borrower pledges cash or cash equivalents, like CDs.
Typically, pledged assets must be securities issued by large,
publicly traded companies, have a trading price of at least $5 per
share and cannot be shares owned in a retirement account. Finally,
the pledge account must be maintained at or above a certain level.
If an account falls below the minimum, the lender will call upon
the borrower to make up the difference.
Pledged-asset loans by the numbers
A pledged-asset loan can be an excellent mortgage product for the
homeowner who expects that his investments and tax savings will be
greater than the interest to be paid on the amount of the foregone
down payment. Simply put, if a homeowner can borrow mortgage funds
at 5.5 percent and keep his investment portfolio intact, earning
more than 5.5 percent in that portfolio, then he will have
benefited from a positive arbitrage situation.
For borrowers considering a pledged-asset loan, theres a simple
formula to determine if it makes sense for them. Using annualized
interest rates, borrowers should take the expected percentage
return on their pledged assets that will remain invested (instead
of being liquidated to pay for a down payment on a home) and
subtract the interest that will be paid on the amount of the loan
that represents the foregone down payment. If the result is
positive, then the homeowner should explore a pledged-asset loan as
a financing option. But pledged-asset loans shouldnt be considered
as a vehicle for just financing ones personal home. For many fans
of pledged-asset loan products, these mortgages have been used as a
means to help their adult children get into a home or even
assisting their own elderly parents in buying a unit in a
retirement community. By simply placing their marketable securities
into a lender-approved margin account, many baby boomers and people
caught in the so-called sandwich generation (adults with elderly
parents and young children) can provide for their loved ones
without liquidating their assets. Best of all, its not necessary
for these borrowers to cosign the loan with the persons they are
assisting; they only need to help provide the assets that replace
the down payments. And remember that some lenders allow the owner
of the pledged account to trade inside the account, as long as he
maintains the minimum required balance in that account.
Not surprisingly, pledged-asset loans are also popular among
homeowners looking for innovative and financially savvy ways to
finance a second home or investment property. While these borrowers
may not enjoy some of the same tax benefits from a second home as
they would from a primary residence, the pledged-asset loan often
plays a significant role in acquiring additional investments
without having to liquidate assets.
In summary, the pledged-asset loan is a solid financial planning
tool that can benefit several different types of sophisticated
borrower. It can be a great tool for homebuyers and their financial
planners who are seeking the most advantageous times to liquidate
assets in order to reduce mortgage debt. It can also offer
borrowers the opportunity to postpone liquidating assets until the
time that such action fits their overall financial goals. However,
pledged-asset loans should not be used for the purpose of
over-leveraging the homebuyer. They are merely loan products that
will allow homeowners to maximize the benefits of their investment
portfolios and be able to more appropriately plan their overall
financial strategies.
Joseph Badal is the senior executive vice president and
chief lending officer of Santa Fe, N.M.-based residential mortgage
lender Thornburg Mortgage. He may be reached at (888) 898-8698 or
e-mail
[email protected].
