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 Funds withdrawn from a securities account are, by definition, no longer at play in the market.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].
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