Definition and Examples of Unsecured Loans
An unsecured loan is a type of loan that allows the borrower to use the value of the securities they own, such as stocks or mutual funds, as collateral for purposes other than purchasing additional investments. The unsecured loan is extended by a broker or dealer using the securities in the investor’s account as collateral. They cannot be used to buy, hold, or trade securities such as stocks or bonds. Unsecured loans are subject to strict regulations to ensure that brokers and dealers do not lend individuals more money to purchase securities than allowed by the securities and exchange authority.
How Does an Unsecured Loan Work?
If an investor has securities in their account, they may qualify for an unsecured loan. This will allow the investor to keep their invested funds and continue to earn returns and profits. Investors may be able to borrow between 50% to 70% of their diversified investment portfolio, although the value can vary depending on the loan requirements.
Investors who secure unsecured loans must keep the securities that collateralize the loan in a separate cash account that is fully paid. If the value of the account with the securities that act as collateral for the loan falls below the required collateral threshold, the investor may be subject to maintenance calls. These calls notify the investor that they must deposit more funds or repay the loan within a specified time frame. If the investor fails to take either action, the securities may be liquidated.
Note: The Federal Reserve requires all borrowers to complete a compliance form to approve the terms of the unsecured loan and related obligations.
Unsecured Loans vs. Margin Loans
Investors may also obtain another type of loan against the value of their securities: a margin loan. Margin loans involve borrowing to purchase more stocks and using existing stocks as collateral. There are strict requirements for margin loans, including minimum deposit requirements, and investors can only borrow up to 50% of the purchase price of the securities that can be bought on margin.
Unsecured loans differ significantly from margin loans because they explicitly prohibit the use of borrowed funds to purchase securities. Investors can borrow a larger percentage of the value of their accounts (depending on the broker’s policy).
Note: Unsecured loan funds cannot be used directly or indirectly for investing in stocks, bonds, or other similar investment products.
Advantages and Disadvantages of Unsecured Loans
Unsecured loans come with several important advantages and disadvantages.
Advantages:
- Lower interest rates: They are often less than other types of loans.
- Securities can be used as collateral: Investors can use their securities to help qualify for a loan without having to sell their investments.
- Quick approval process: Obtaining an unsecured loan often requires less documentation compared to other traditional financing products.
- No closing costs or fees: There are usually no closing costs or other fees associated with most unsecured loans.
Disadvantages:
- Additional collateral may be required: Investors may need to deposit more funds or sell securities if their account balance falls too low while the account is serving as collateral.
- Interest rates can increase at any time: Interest rates can rise, making loans more expensive.
- Use of funds may be restricted: While the investment account serves as collateral, you may be restricted in what you can do. For example, you may not be allowed to trade options.
Alternatives to Unsecured Loans
Secured loan: A borrower can take a different type of secured loan, such as a mortgage loan, which will be secured by the value of the home used to purchase the property.
Loans
Unsecured Loans: A borrower can take out an unsecured loan, such as a personal loan, which does not require collateral to secure repayment from the borrower. Unsecured loans not backed by securities often have stricter eligibility requirements, such as a full credit and income assessment to determine the likelihood that the borrower will repay the debt. These loans may have higher interest rates than secured loans.
Key Takeaways
Investors can use the value of their securities as collateral to secure an unsecured loan. Unsecured loans allow investors to maintain their investment account balance while gaining liquidity. There are strict rules regarding the amounts that investors can borrow against their accounts to purchase other investments. Unsecured loans differ from margin loans, where securities are used as collateral to buy other investments. Borrowers may need to complete a form that specifies the amount they are borrowing and how they will use the proceeds from the unsecured loan.
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Sources:
– TD Ameritrade. “Collateral Lending.” Accessed Aug. 16, 2021.
– Charles Schwab Bank. “Schwab Bank Pledge Asset Line.” Accessed Aug. 16, 2021.
– U.S. Securities & Exchange Commission. “Margin: Borrowing Money To Pay for Stocks.” Accessed Aug. 16, 2021.
– Fidelity. “Margin Loans.” Accessed Aug. 16, 2021.
– MyCreditUnion.gov. “Personal Loans: Secured vs. Unsecured.” Accessed Aug. 16, 2021.
Source: https://www.thebalancemoney.com/what-is-a-non-purpose-loan-5197622
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