Clients looking to raise short-term cash often sell assets to generate liquidity. Maybe they need to pay school tuition, acquire an automobile, make home improvements or pay their taxes, but quickly liquidating long-term assets to do it is hardly tax-efficient.

For that reason, many clients are turning to an increasingly popular alternative: borrowing using their securities, such as stocks and funds, as collateral. It’s a tax-efficient and convenient option that gives the borrower flexibility in meeting their cash needs without greatly disrupting their wealth planning.

The ABCs Of Securities Lines Of Credit
The bankers offering these loans refer to it as securities-based lending, and it’s important to understand the basics.

There are two ways you can borrow. One of these involves “purpose lines,” also commonly known as “margin lines.” With these, you can borrow from a bank using your own securities as collateral—and then acquire even more securities to add to your existing portfolio.

Then there are non-purpose lines. With these, you can borrow for a wide variety of other needs, including tax payments, school tuition, automobile and home purchases or renovations—or any other purchases that are not related to new securities investments.

The amount of credit available for a non-purpose securities-based line is based on an advance rate against the collateral of the account. This is very similar to a loan-to-value amount that banks are willing to lend when a client is financing a home purchase through a residential mortgage. Advance rates for purpose lines of credit are limited to 50% of the account value, while non-purpose lines can be higher, depending on the collateral, along with borrower’s credit. In both cases, it’s simple to establish lines of credit, since the required documentation is very minimal. And unlike most other credit types, a securities-based line earns approval mainly because of the collateral value of the portfolio.

The other advantage of a securities-based line of credit is its affordability. There is usually not a fee to establish a line of credit, and the only cost the client will likely incur is an interest expense when the line is used. Since the credits are secured by liquid collateral, the interest rates are typically attractive, especially if the borrower is using the line only for true short-term cash obligations. Most lines of credit have floating interest rates based on an index, such as the prime rate or secured overnight financing rate, with an appropriate spread attached.

Securities-Based Lines Of Credit Versus Asset Sales
There are many reasons to have a securities-based line of credit available. One reason is that your client can avoid otherwise selling an asset quickly or unnecessarily (and paying the corresponding taxes) just to get fast access to cash. The timing of such a sale can affect the client’s wealth plan, given the potential long-term capital gain taxes and recognition of unnecessary losses. Also, there’s the opportunity cost: By liquidating assets in the stock market, your client might miss out on greater returns.

The tables compare the two choices at hand.

Securities-Based Credit Versus Mortgage-Based Financing
An alternative to a securities-based line of credit is a home equity line of credit or a cash-out mortgage refinancing. There are pros and cons to these financing options. One benefit of residential mortgage-based lending is that the credit commitment is typically longer, there is a long-term fixed interest rate, and some of the client’s interest expense is tax-deductible. On the other hand, the time from application to approval is longer than it would be in a securities-based facility. Furthermore, residential lending solutions require a significant amount of documentation—such as tax returns, bank statements and paychecks—and the bank will perform an appraisal on the home. Alternatively, the largest benefit of a securities-based line of credit is the ease of qualifying and establishing the facility.

Market Volatility: Managing The Risk
Securities-based lines do come with some risk. If the advance rate is too high and the value of the collateral declines substantially, the portfolio might have to be liquidated to pay off the outstanding balances. It is important to know the trigger points, or default rates, when this will occur, and to understand the bank’s procedure for notifying clients if the advance rate becomes an issue. If a credit line does exceed the default rate and the lender sells assets to pay down the outstanding credit, this can spur the same tax consequences the client was trying to avoid. So it’s important for the client to closely monitor the line of credit against the value of the portfolio, especially when markets are volatile or suffering sustained downturns.

Clients should look for lenders who will be proactive, communicating with them early on if there are margin problems, which is especially important during periods of market turmoil. It’s critical for the client and wealth team to work together (and talk regularly) to explore alternatives to liquidation. For instance, a client could add unencumbered liquid assets to the collateral, use excess cash to pay down the lines, or liquidate only those assets that will trigger minimal taxes. While automatic liquidation of assets is an option on these lines of credit, a lender may be able to work with the client to avoid it. But even with or without constant communication, the clients must know that it’s 100% their responsibility that the credit remain within margin. 

Part Of Your Plan
In any case, a securities-based line of credit should be an integral part of a client’s wealth management plan. Whether or not a client needs financing, such credit lines offer them more financial flexibility at a lower cost. Moreover, these facilities let clients leave their assets in the market to potentially capture additional returns and avoid tax consequences—thus affording them the opportunity to maintain or further build wealth.         

Dan Sullivan is a managing director and head of private banking and mortgage for CIBC Private Wealth, U.S., with more than 25 years of industry experience. In this role, he is responsible for developing client relationships to deliver CIBC’s broad array of wealth solutions to clients.