Securities-Backed Line of Credit (SBLOC)

A securities-backed line of credit is a line of credit, offered by brokerage firms (many of them through an affiliated bank), that is secured by securities held in the borrower's investment account. FINRA describes SBLOCs as "a type of securities-based lending offered to investors," set up as a revolving line of credit that requires "monthly, interest-only payments" and remains outstanding until repaid. The borrower can repay and redraw at any time and can keep trading in the pledged account. The defining restriction is the use of the money: SBLOCs are non-purpose loans, which FINRA explains means "you can't use the proceeds to purchase or trade securities." The name also appears as securities-based line of credit; both describe the same product.

Why the purpose rule exists. Federal margin regulation treats credit used to buy securities differently from other credit. The Federal Reserve's Regulation U defines purpose credit as "any credit for the purpose, whether immediate, incidental, or ultimate, of buying or carrying margin stock," and limits how much of it a lender can extend against stock. Borrowing to buy securities belongs in a margin account. An SBLOC is set up as non-purpose credit, so the lender's agreement forbids using it to buy securities.

How limits and rates are set. FINRA reports that a typical SBLOC agreement allows borrowing of 50 to 95 percent of the account's value, depending on the size of the holdings and the kinds of assets, that firms often require $100,000 or more in eligible assets, and that eligible collateral generally means stocks, bonds and mutual funds held in fully paid-for cash accounts. Rates are usually variable, built as a spread over a reference rate such as the prime rate or SOFR, with interest calculated daily and charged monthly, and some firms offer a fixed rate. FINRA notes rates are often lower than on a personal loan or a credit card, and some lenders set the limit from the portfolio alone without a credit check.

The risks that are easy to miss. The lender controls three things the borrower does not. It can decide a security no longer counts as collateral, shrinking the amount that can be borrowed. Some agreements let it raise the share of collateral the borrower must maintain. And FINRA notes SBLOCs "are classified as demand loans, which means lenders may call the loan at any time." When the collateral falls, a maintenance call follows, and if it is not met the firm can sell holdings, often without notice, possibly at the bottom of a decline and with capital gains tax on the sales. FINRA also states that these loans "can be a key revenue source for securities firms," which is worth knowing when one is offered as a feature of an account.

Borrowing instead of selling. Because a loan is not a sale, an SBLOC lets an investor with large unrealized gains raise cash without realizing them, and FINRA notes some firms market SBLOCs as part of a retirement income strategy. The investor keeps the holdings, their dividends and their appreciation, but also keeps the debt and the market risk on the collateral. How the interest is treated for tax depends on what the money is used for.

What cannot be pledged. The tax code says that if the owner of an individual retirement account "uses the account or any portion thereof as security for a loan, the portion so used is treated as distributed to that individual." So SBLOCs are a taxable-account product; an IRA used as collateral stops being an IRA to that extent.

Consider an example of how a maintenance call arises. Nikhil pledges a $500,000 portfolio of diversified ETFs, and his lender allows borrowing up to 70 percent of the collateral's value, a $350,000 limit. He draws $200,000 at a variable rate that currently totals 6.5 percent, so his interest-only payment is about $1,083 a month ($200,000 times 6.5 percent, divided by 12).

Assume, to keep the arithmetic simple, that the lender requires the loan to stay within that same 70 percent of the collateral's current value. If the market falls 30 percent, the portfolio is worth $350,000 and 70 percent of it is $245,000, still above his $200,000 balance, so nothing happens. If it falls 45 percent instead, the portfolio is worth $275,000 and the allowed balance is $192,500 (70 percent of $275,000). He is $7,500 over, and the lender issues a maintenance call. He can repay $7,500, or pledge more securities: because only 70 percent of new collateral counts, that means about $10,714 of additional holdings ($7,500 divided by 0.70). If he does neither within the call period, the lender can sell enough of the ETFs to close the gap, at the depressed price, and in a taxable account any gain on those sales is taxable to him.

Pros

• Raises cash without selling, so there is no capital gains tax from the borrowing itself and the holdings stay invested.
• Interest-only payments and the ability to repay and redraw at any time make it flexible for short-term needs.
• Rates are often lower than unsecured borrowing, and approval can be fast.

Cons

• A market decline can trigger a maintenance call within days and a forced sale at a low price, with the tax on any gains.
• The loan is a demand loan, and the lender can change which securities count as collateral or how much must be maintained.
• Variable rates rise when the reference rate does, and interest-only payments never reduce the balance.
• Using the money to buy securities is not allowed, and an IRA cannot serve as collateral.
• The firm earns revenue from the loan, which is a reason to compare it with other ways of raising the same money.