PLEDGED ASSET LINES
What is a Pledge Asset Line (PAL)?
A Pledge Asset Line, or Security Backed Line of Credit, is a type of loan that allows borrowers to use their investment portfolio as collateral to obtain credit.
This form of credit line offers the flexibility to access funds without having to sell investments, potentially avoiding capital gains taxes and keeping investment strategies intact.
Interest rates for these lines are typically lower than unsecured loans due to the lower risk associated with lending against marketable securities.
How do PAL lines work?
When utilizing a Pledge Asset Line or Security Backed Line of Credit, borrowers pledge their investment assets, such as stocks or bonds, as collateral to secure a loan.
The lender assesses the value of the securities and offers a credit line up to a certain percentage of that value, providing liquidity while allowing the borrower to remain invested in the market.
Interest is charged on the amount drawn from the line of credit, and if the value of the pledged securities falls below a certain threshold, the borrower may be required to deposit additional assets or repay part of the loan to maintain the loan-to-value ratio.
What are Advance Rates?
An advance rate is the percentage of a collateral's value that a lender is willing to extend as a loan or credit line to a borrower.
This rate determines how much money the borrower can access based on the value of the collateral pledged. The advance rate helps manage the lender's risk, ensuring that there is sufficient collateral to cover the loan amount in case of default and the need to liquidate the assets.
For example, an advance rate of 70% would indicate that you can borrow up to $70,000 for everyone $100,000 of portfolio value.
Advance rates for Pledge Asset Lines (PAL) typically vary between 50% to 70% of the pledged securities' value, depending on the type of asset and the lender's policies.
Equities (stocks) usually have lower advance rates, often ranging from 50% to 70%, due to their volatility. In contrast, bonds or other fixed-income securities might have higher advance rates, sometimes up to 80% to 95%, because they are generally considered less volatile.
The specific advance rate offered is determined by factors such as the asset's marketability, the volatility of the underlying securities, the concentration of the portfolio, and the overall creditworthiness of the borrower.
What are the biggest risks of a PAL line?
The major risk associated with a PAL line is a substantial market decline and a subsequent market call. In the event of a market decline, it is possible that the collateral value of your investments will no longer be large enough to support the loan against the account.
When this occurs, you are required to either pledge additional collateral quickly or liquidate holdings in the account at a permanent loss. This is a very material risk for PAL lines and usually makes them unattractive unless the loan balance is kept to a very small percentage of the overall account.
Stick to a sound rule of thumb
In general, it is wise to avoid using PAL lines when alternative methods of credit are available.
In the rare event that a PAL line makes financial sense as the best option, it is prudent to maintain a loan-to-value ratio of less than 20% to avoid a permanent loss of capital in the event of a sharp, but temporary, market decline.
Calculator
The calculator below can be used to demonstrate the risks associated with maintaining a PAL line in a market decline.
The calculators on the site provide a high level overview of your financial picture. For comprehensive planning, schedule a meeting.
