Pledged Asset

What Is a Pledged Asset?

A pledged asset is a valuable possession that is transferred to a lender to secure a debt or loan. A pledged asset is collateral held by a lender in return for lending funds. Pledged assets can reduce the down payment that is typically required for a loan as well as reduces the interest rate charged. Pledged assets can include cash, stocks, bonds, and other equity or securities.

Understanding Pledged Assets

The borrower will transfer a pledged asset to the lender, but the borrower still maintains ownership of the valuable possession. Should the borrower default, the lender has legal recourse to take ownership of the asset pledged. The borrower retains all dividends or other earnings from the asset during the time it is pledged.

The asset is merely collateral for the lender in the event of borrower default. However, for the borrower, the pledged asset could help considerably with gaining approval for the loan. Using the asset to secure the note may let the borrower demand a lower interest rate on the note then they would have had with an unsecured loan. Typically, pledged-asset loans provide borrowers with better interest rates than unsecured loans.

Once the loan is paid off and the debt is fully satisfied, the lender transfers the pledged asset back to the borrower. The type and value of pledged assets for a loan are usually negotiated between the lender and borrower.

Pledged-Asset Mortgage

Homebuyers can sometimes pledge assets, such as securities, to lending institutions to reduce or eliminate the necessary down payment. With a traditional mortgage, the house itself is the collateral for the loan. However, banks usually require a 20% down payment of the value of the note, so that buyers do not end up owing more than their home's value.

Also, without the 20% down payment, the buyer must pay a monthly insurance payment for private mortgage insurance (PMI). Without a significant 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 secure a lower interest rate. For example, let's say a borrower is looking to buy a $200,000 house, which requires a $20,000 down payment. 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 seize the assets if the borrower defaulted on the mortgage. The borrower continues to earn capital appreciation on the pledged assets and gets a no-down-payment mortgage.

Using Investments for a Pledged-Asset Mortgage

A pledged-asset mortgage is recommended for borrowers that have the cash or investments available and don't want to sell their investments to pay for the down payment. Selling the investments might trigger tax obligations to the IRS. The sale may push the borrower's annual income to a higher tax bracket resulting in an increase in their taxes owed.

Typically, high-income borrowers are ideal candidates for pledged-asset mortgages. However, pledge assets can also be used for another family member to help with the down payment and mortgage approval.

Qualifying for a Pledged-Asset Mortgage

To qualify for a pledged-asset mortgage, the borrower usually needs to have investments that have a higher value than the amount of down payment. If a borrower pledges security and the value of the security decreases, the bank may require additional funds from the borrower to make up for the decline in the asset's value.

Although the borrower retains discretion as to how the pledged funds are invested, the bank may impose restrictions to ensure the pledged assets are not invested in financial instruments that are deemed risky by the bank. Such risky investments may include options or derivatives. Further, assets in an individual retirement account (IRA), 401(k), or other retirement accounts cannot be pledged as assets for a loan or mortgage.

Pros and Cons of a Pledged-Asset Loan or Mortgage

The use of pledged assets to secure a note has several advantages for the borrower. However, the lender will demand a specific type and quality of investments before they will consider underwriting the loan. Also, the borrower is limited to the actions they may take with the pledged securities. In dire situations, if the borrower defaults they will lose the pledged securities as well as the home they purchased.

The borrower must continue to report and pay taxes on any earnings they receive from the pledged assets. However, since they were not required to sell their portfolio holdings to make the down payment, it will not place them into a higher tax income bracket.

Real World Example of a Pledged-Asset Mortgage

Raymond James Bank offers a pledged securities mortgage whereby the pledged assets are maintained in an investment account with Raymond James. Some of the features and stipulations include: