What is a pledged asset?
A collateral is a valuable asset that is transferred to a lender to secure a debt or loan. A pledged asset is collateral held by a lender in exchange for loan funds. Pledged assets can reduce the down payment that is generally required for a loan as well as the interest rate charged. Pledged assets may include cash, stocks, bonds, and other stocks or securities.
Explanation of the promised assets
The borrower will transfer collateral to the lender, but the borrower still retains ownership of the precious asset. In the event of default by the borrower, the lender has legal recourse to appropriate the pledged asset. The borrower retains all dividends or other income from the asset for the duration of its pledge.
The asset is only a guarantee for the lender in the event of default by the borrower. However, for the borrower, the pledged assets could greatly assist in obtaining loan approval. Using the assets to secure the note can allow the borrower to charge a lower interest rate on the note than he would have done with an unsecured loan. Generally, secured asset loans offer borrowers better interest rates than unsecured loans.
Once the loan is repaid and the debt is fully satisfied, the lender transfers the pledged asset to the borrower. The type and value of assets pledged for a loan are usually negotiated between the lender and the borrower.
Key points to remember
- A collateral is a valuable asset that is transferred to a lender to secure a debt or loan.
- Pledged assets can reduce the down payment that is generally required for a loan.
- The asset may also offer a better interest rate or better repayment terms for the loan.
- The borrower retains ownership of the assets and continues to earn interest or capital gains on those assets.
Mortgage on pledged assets
Home buyers can sometimes pledge assets, such as securities, with credit institutions to reduce or eliminate the down payment required. With a traditional mortgage, the house itself is the collateral for the loan. However, banks generally require a deposit of 20% of the value of the note, so that buyers do not end up owing more than the value of their home. In addition, without the 20% deposit, the buyer must pay monthly insurance for private mortgage insurance (PMI). Without a large down payment, the borrower will likely also have a higher interest rate.
The pledged asset can be used to eliminate the down payment, avoid PMI payments and guarantee a lower interest rate. For example, suppose a borrower is looking to buy a home for $ 200,000, which requires a down payment of $ 20,000. If the borrower has $ 20,000 in stocks or investments, they can be pledged to the bank in exchange for the down payment.
The borrower retains ownership of the assets and continues to earn and report interest or capital gains on those assets. However, the bank would be able to foreclose on the assets if the borrower defaulted on the mortgage. The borrower continues to gain capital appreciation on the pledged assets and obtains a mortgage without down payment.
Use of investments for a pledged mortgage
A secured asset mortgage is recommended for borrowers who have cash or investments available and do not want to sell their investments to pay the down payment. The sale of investments may result in tax obligations to the IRS. The sale could push the borrower’s annual income to a higher tax bracket, which would increase their taxes owed.
Generally, high-income borrowers are ideal candidates for secured asset mortgages. However, pledge assets can also be used for another family member to help with the down payment and mortgage approval.
Eligibility for a mortgage on pledged assets
To be eligible for a mortgage on pledged assets, the borrower must generally have investments of a value greater than the amount of the down payment. If a borrower pledges a security and its value decreases, the bank may require additional funds from the borrower to offset the decline in the value of the asset.
Although the borrower retains its discretion as to how the collateral is invested, the bank may impose restrictions to ensure that the collateral is not invested in financial instruments deemed risky by the bank. These risky investments may include options or derivatives. In addition, the assets of an individual retirement account (IRA), 401 (k) or other retirement accounts cannot be pledged as assets for a loan or mortgage.
Advantages and disadvantages of a loan or mortgage
Using collateral to secure a note has several advantages for the borrower. However, the lender will require a specific type and quality of investment before considering taking out the loan. In addition, the borrower is limited to the steps he can take with the collateral. In dire situations, if the borrower defaults, he will lose the collateral and the home he bought.
The borrower must continue to report and pay taxes on all income that he receives from the pledged assets. However, since they were not required to sell their portfolio holdings to make the down payment, this will not place them in a higher tax income bracket.
A pawnbroker loan allows the borrower to retain ownership of the precious asset.
Borrower avoids tax penalties or taxes on capital gains from the sale of assets
Pledging assets avoids large down payments on loans and PMI, if applicable.
The borrower may receive a lower interest rate on the loan or mortgage.
The borrower continues to earn income and must declare the gains from his investments.
The ability to trade collateral may be limited if the investments are stocks or mutual funds.
The borrower could lose both the house and the securities in the event of default.
By not making a deposit, the interest on the loan is paid on the total price of the property.
If the value of the collateral falls, the lender may require additional funds.
Pledging assets for a parent’s loans carries a risk of default as there is no control over the repayment of the borrower.
Real example of mortgage with pledge
Raymond James Bank offers a secured securities mortgage whereby the pledged assets are kept in an investment account with Raymond James. Some of the features and stipulations include:
- Customers can finance up to 100% of the purchase price of a principal residence as well as a residential investment property
- Uses a combined pledge of real estate and margin-eligible securities
- Down payment is eliminated with 100% financing
- Avoids liquidation of investments and possible taxes on capital gains
- No PMI insurance
- Also offers asset-based mortgages for family members
- If the value of collateral falls, Raymond James will need additional funds to pledge
- Raymond James also reserves the right to liquidate the securities without prior consent if necessary to consolidate the account