What Is a Pledged Asset
A pledged asset is an asset that's transferred to a lender for the purpose of securing debt. A pledged asset is collateral held by a lender in return for a loan. Pledged assets can reduce the down payment that's typically required for a loan as well as reduce the interest rate charged on a loan.
Pledged Assets Explained
A pledged asset is transferred to the lender from the borrower, but the borrower maintains ownership of the asset. If the borrower defaults on the loan, the lender has legal recourse to take possession of the asset that was pledged. The asset is merely collateral for the lender in the event of a default. However, for the borrower, the pledged asset could help considerably with gaining approval for the loan or securing better terms such as a lower interest rate or payment. 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 amount of pledged assets for a loan are usually negotiated between the lender and borrower.
Pledged assets can include:
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 used as collateral for the loan. However, banks usually require a 20% down payment, so buyers do not end up owing more than their home's value. Without the down payment, the buyer pays a monthly insurance payment for private mortgage insurance (PMI). The borrower will likely also have a higher interest rate without a down payment.
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 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.
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 a tax payment to the IRS or 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 a 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 options or derivatives. Assets in an individual retirement account (IRA), 401(k), or other retirement accounts cannot be pledged as assets for a loan or mortgage.
- A pledged asset is an asset that's transferred to a lender for the purpose of securing debt.
- Pledged assets can reduce the down payment that's typically required for a loan as well as reduce the interest rate charged on a loan.
- The borrower retains ownership of the assets and continues to earn interest or capital gains on those assets.
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:
- Clients can finance up to 100% of the purchase price of a primary home 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 investment liquidation and any potential capital gains taxes
- No PMI insurance
- Offers pledged asset mortgages for family members as well
- If the pledged securities decline in value, Raymond James will require additional funds to be pledged
- Raymond James also reserves the right to liquidate the securities without prior consent if needed to shore up the account
Pros and Cons of a Pledged-Asset Loan or Mortgage
A pledged-asset loan allows the borrower to retain the assets and earn income from potentially lucrative investments
Borrower avoids tax penalties or capital gains taxes from selling the assets
Avoids down payment on the loan or mortgage and no PMI, if applicable
Lower interest rate on the loan or mortgage
The ability to trade the pledged securities might be limited if the investments are stocks or mutual funds
The borrower could lose both the home and the securities in the event of default
By not making a down payment, interest is paid on the full price of the property
The pledged-asset mortgage could cost the borrower more money if the securities decline in value combined with the total interest paid on the full price of the property
Pledged assets for relatives carries default risk since there's no control over the borrower's financial situation