Some folks are using their investment portfolios as collateral for down payments on houses. Are they mad?
This spring, countless Americans will scour real estate Web sites, pore over classified ads and flock to open houses in search of a piece of the red-hot housing market. And many of them will be worried sick that the values of the houses they're about to buy will plunge the moment they sign their closing papers, as the much-prophesied housing collapse begins.
The most adventurous buyers might be interested in financing their purchases with little-known vehicles called pledged-asset mortgages. These loans allow consumers to use their investment portfolios as collateral for mortgages -- rather than gather together a traditional down payment -- while still qualifying for the most competitive mortgage rates. The benefit: Rather than tie up money in real estate, they can remain invested elsewhere. (We'll explain the mechanics later.)
Risky? You bet.
Pledged-asset mortgages are available only to those with sizable investment portfolios -- and thus much to lose. Should the stock market fall and the investments pledged as collateral drop in value, holders could be faced with the equivalent of a margin call. And if they can't come up with the money to satisfy the call, their personal balance sheets could look like Enron's circa 2002.
Pledged-asset mortgages aren't new: Large brokerage firms began offering them in the early 1990s, as the stock market began to soar. At the time, pulling money out of the stock market to invest it in boring old real estate seemed anything but desirable -- and therefore these loans seemed attractive. But when the technology bubble burst, the products fell out of favor, explains Darren Weisberg, president elect of the Illinois Association of Mortgage Brokers.
Nowadays, however, the NASD (formerly the National Association of Securities Dealers) worries that these loans could start garnering more attention. Last year, for example, Charles Schwab began offering pledged-asset mortgages.
The rationale for pledged-asset mortgages is simple: As predictions of a real-estate bubble proliferate, the stock market might soon seem like a safer investment. Folks who believe stocks will outperform real estate in the future -- as they have for most of the last 100 years -- might choose to hang onto their winners and avoid paying the capital gains taxes and transaction fees their brokers charge.
Even if you agree with this outlook, is a pledged-asset mortgage right for you? We'll be honest: Probably not. In fact, the NASD has issued an "Investor Alert" warning people of the risks of these loans. But in certain circumstances, they can make sense. Here's what you need to know.
How does a pledged-asset mortgage work? It's a bit like buying a house on margin.
Borrowers set aside a portion of their investment portfolio, say, 35% to 45% of the home's value, into a separate "pledge" account that acts as collateral for a 100% mortgage. While they still own the securities in the account, their trading activities are limited. They get a mortgage through their broker, and aren't socked with nasty private mortgage insurance payments that typically accompany mortgages with less than 20% down. (Retirement accounts can't be used as collateral for pledged-asset mortgages.)
Should the assets in the pledge account drop below a predetermined level, say, 110% of the required pledge amount, the borrower could get what's known as a collateral call. When this happens, the borrower is required to deposit cash or other securities into the account to prop it back up to appropriate levels.
Pledged-asset mortgages obviously aren't for the timid.
If the stock market falls and you don't have the cash to satisfy a collateral call, you could be forced to sell the securities in your pledge account as well as other investments to raise the value of your account, warns John Gannon, vice president of investor education of NASD.
Be warned: In a volatile stock market, the brokerage firm could sell your securities to meet the collateral call without contacting you. Moreover, you aren't entitled to choose which securities in your account are sold to meet the call, says Gannon.
And here's a truly bleak scenario: Should you default on your mortgage for any reason, you could lose your house and your securities.
When They Make Sense
There are times when pledged-asset mortgages are viable options for borrowers. Think back to the late 1990s, when stocks were a far better investment than real estate. If you think a repeat of that scenario is in the offing, as some on Wall Street believe, then you wouldn't want to sell your equities and put the post-tax proceeds into a down payment on a house. With a pledge account, while your securities are set aside, you'd still own them. So if the market rallies, you wouldn't miss out.
Are you selling one house and buying another? If you can't coordinate the closings on the same day, a pledged-asset mortgage could come in handy as a bridge loan, suggests Richard Musci, chief marketing officer for Charles Schwab. Rather than sell a large portion of your investments and pay the capital gains to fund the down payment on your new home, you could take out a pledged-asset mortgage and deposit the proceeds from the first house into the pledged account once it sells. (Of course, there are other, less risky ways to handle this situation.)
Perhaps you want to help your adult child qualify for a mortgage with a competitive interest rate. Some brokerage firms, such as Merrill Lynch, as well as mortgage powerhouses Fannie Mae and Freddie Mac, allow parents and grandparents to pledge some of their assets as collateral for their kids' or grandchildren's 100% mortgage. (Fannie Mae and Freddie Mac require only a 5% pledge, but the pledge must be made up of certificates of deposit.) Just make sure Junior has a high enough income to pay off that loan each month, or mom and dad risk losing their securities, warns Illinois Association of Mortgage Brokers' Weisberg.
Limiting Your Risks
If you decide to take one of these loans, there are a couple of things you can do to help protect yourself. To reduce the likelihood that your pledge account falls below your brokerage firm's requirement, diversify your investments, advises NASD's Gannon. Rather than holding just one stock in that account, include a mix of companies, as well as bonds and mutual funds. That way, if one stock falls drastically on poor earnings results, your entire portfolio won't be crushed.
It's also important to monitor your account constantly. If you see it falling in value, consider depositing more money into it before you get a collateral call. This way, you can stop your brokerage firm from selling off investments you want to keep.
Of course, if you find yourself constantly depositing money into the pledge accounts to meet collateral calls, you might have made a mistake in taking on a pledged-asset mortgage instead of simply plunking down the cash in the first place. While the returns in real estate might not be as high over the long term, Gannon argues, consumers shouldn't think of their homes merely as investments. This is, after all, the only investment you've got that also keeps you warm at night.