Using Your Investment Portfolio As Collateral

Borrowing against your investments can be an easy way to raise cash and it is usually as easy as filling out paperwork in the financial institutions.

When you want to obtain a loan from a bank or some other financial institution, one of the things they require is a collateral. A collateral serves as security for your loan. It is required by the lender as a form of assurance that they won’t lose all of their money if you default.

With a collateral, in the case of a default, the lender can convert the pledged asset to money by selling it, to get their money back. Consequently, having something to pledge as a collateral makes it possible to obtain loans in the first place.

While every individual in Nigeria has a credit score, the concept isn’t common here. As such, your best bet at getting a loan is having a good collateral to back it up.

How Collaterals Work

When you pledge an asset that costs N500,000, the financial institution giving you the loan might only give you a loan worth half of that asset. As such, you might be able to only take a loan of N250,000.

The idea behind this is that they would still be able to get their money back even depreciation of the asset or any other thing that causes it to drop in value. This is what is regarded as a loan to value ratio (LTV) and the ratio isn’t always 50% - it could be up to 80%. It is, however, determined by the lender.

__Using Investments as Collateral__

The popular kinds of collateral are fixed assets like houses, cars, large business machinery, and so on. However, not many people know that their investments can also serve as a collateral.

Your investment portfolio or stock investment can be used to back up a loan. Borrowing against your investments can be an easy way to raise cash and it is usually as easy as filling out paperwork in the financial institutions.

Using the same LTV ratio based on their own terms, they can either give you up to the full amount of the security it is backed against or account for a possible reduction in asset value. Shares in publicly quoted companies are acceptable for securing both business loans and personal loans.

One of the advantages of using investments as collateral is that they are significantly faster to process as you really just need to show proof of their existence (share certificates, etc.).

However, because of the inherent volatility of stock investments, there are also a number of risks to be wary of.

Risks Of Using Investments As A Collateral

The most apparent risk comes with default. Where you cannot make the regular loan payments as agreed or you have cause to default the loan repayment generally, then you might lose your investment portfolio or significant portions of it.

This is because the lender may move up on your investment and because of its long-term effect, you could generally lose a huge chunk of your net worth.

Another risk is that when the value of the securities start reducing, the lender can demand for additional collateral and this could be on a very short notice. Default of this can lead to severe consequences as well.

For example, while a lot of brokerage houses will notify you before they sell your stocks or bonds (popularly regarded as a margin call), but they are not required to.

A way to circumvent these risks is that you borrow a small amount compared to the value of your portfolio – say 20%. That way, even when things go wrong, you still have flexibility to make decisions and your losses would not be too wild.

It is also important that before you use your portfolio as a collateral, you seek professional advisory help or at the very least, compare the costs and possible risks to the losses that could arise from it.

Written by Lawretta Egba.