Collateralizing Assets: A Valuable Investment Tool That Requires a Measured Approach
If there ever was a double-edged sword in investing, it is collateralizing assets. On one hand, it can allow investors to magnify their investment returns, but on the other, it can endanger an investor’s existing portfolio if used irresponsibly.
Collateralizing involves pledging an existing asset already in your possession in order to secure additional capital through loans to meet your needs. The major difference between a collateralized (“secured”) loan and a non-collateral (“unsecured”) loan is the likelihood of being approved for the capital needed. A lender will be much more willing to provide the capital you request if you can pledge an asset to back the loan. That way, if the loan goes into default, the lender has immediate recourse by seizing and liquidating the asset. A true win-win scenario for both you and the lender.
A Look at the Types of Collateral
Some of the most common forms of collateral are:
Valuables and collectibles
When it comes to creating a collateralization strategy, you need to play to your strengths as an investor. This is where an honest assessment is required. For example, if you have a successful track record in real estate investments, and you currently own a high-priced automobile that carries no debt but also earns no appreciation or cash flow, a sound strategy may include collateralizing the automobile to purchase additional real estate investments. This strategy allows you to turn a flat/negative situation into a positive one.
As one would expect, the strategy quickly falls apart if it flows the other way. If you take a loan on a real estate property to buy additional vehicles that don’t contribute to your prosperity, the result would be a negative hit to your financial health.
What Interest Rate Will You Pay?
This is a tricky question, and it depends directly on the quality of the collateralized asset. Lenders prefer assets that they can easily take possession of and liquidate should you default on your loan. A high-quality liquid asset (HQLA), such as a life insurance policy or a government bond or equity, will help you garner a lower interest rate, while lower-value and illiquid assets usually carry a higher rate.
The Pros of Collateralization
As an investor, sometimes the only thing stopping you from taking on a great deal is access to capital. And many times, that’s the last piece of the puzzle to be solved. Put simply, when you find your investment niche and know how you want to invest, then access to capital becomes the missing link in your portfolio.
There’s an old adage in the investment world that I’m sure you’ve heard: It’s not what you know, but who you know. However, in practice, the ability to bring in capital to a deal is as important as who you know. When you have access to capital, you have the ability as an investor to negotiate terms with leverage. This is critical if you’re looking to progress from a completely passive investor into the active world.
Access to capital also amplifies your ability to multiply your wealth. Any time you can take on favorable debt terms to invest in more favorable terms, you win. At that point, the complications boil down to mathematics: Can you earn a higher return on a prospective investment than the interest you must pay on the debt you need to assume? If the answer is yes, then collateralization can potentially help you build your portfolio. If the answer is no, then it’s a simple no!
But there is another advantage of collateralization that is not talked about enough: the option to borrow without actually borrowing. In other words, you can apply for a loan in order to have cash available, but only use it if you need it. A simple way to think about this is if a homeowner builds up equity in their primary home and only needs to pay the application fee of applying for a home equity line of credit (HELOC). Most times, the fee is less than $100 for the availability of a considerably higher amount of credit. In this case, the cost is an absolute no brainer. The best part of the transaction—besides the low entry costs—is the fact that some collateralized loan products don’t charge you unless you borrow against the equity. This means that hypothetically your interest rates might be zero if you never use it, but you will have the ability to use it if the opportunity presents itself. On many levels, this might be the single greatest benefit of collateralizing an asset.
The Cons of Collateralization
Unfortunately, collateralization sometimes gets confused with investing on margin—which essentially means borrowing money from a stockbroker to buy securities and leverage any potential returns they may yield. In other words, you’re investing with money that is not backed by assets you own, and that typically comes with strict restrictions in place. It can even lead to a forced sale of assets to cover your trade. When this happens, you’re not entitled to a choice of what and when to sell, which can put you in an undesirable position.
The best way to think of collateralization is a hybrid version of a margin account and an unsecured account: It may allow you to borrow money, but there are still some negative consequences.
Is Collateralization Right for You?
The only people that can decide if collateralization is the best option are you and your professional advisors. This is very much a personal question that involves an honest assessment of your personal risk/reward profile. Collateralization involves taking on additional risks that may not be warranted if you have an infinite amount of patience. However, sometimes the risk/reward balance moves in your favor, you may find yourself asking the question, “How do I fund this deal?” Usually, by the time someone needs to ask that question, it’s too late since good deals tend to move fast. The best course of action is to plan ahead when there isn’t a cloud in the sky. That’s when you go and negotiate the purchase of an umbrella.
If you liked this article and wish to continue on your path in learning about alternative investments, please make sure to check out my other educational articles as well as my book, The Alternative Investment Almanac: Expert Insights on Building Personal Wealth in Non-Traditional Ways.
Disclaimer: The information presented in this article is for informational purposes only and does not constitute professional financial or investment advice. The author does not make any guarantees or promises as to the results that may be obtained from it. You should never make any investment decision without first consulting with your own financial advisor and conducting your own research and due diligence. Even though, the author has made reasonable efforts to ensure that the contents of this article were correct at press time. The author disclaims all liability in the event that any information, commentary, analysis, opinions, advice and/or recommendations contained in this article results in any investment or other losses. Your use of the information in this article is at your own risk.