What is a Pledged Asset?
A pledged asset is one that is being used as collateral on a loan. The risk of the lender is reduced because the lender can take possession of and sell the asset where a borrower defaults on loan payments. With a pledged asset, the borrower may be able to negotiate for a reduction in the interest rate charged since the presence of a pledged asset reduces the risk of the lender.
Based on the situation, the lender may decide that the borrower should deposit cash or securities in an account that the lender is in control of. With this, the lender will be able to access the asset in an event of a default, even though the borrower will keep receiving all dividend and interest payments from the security issuers during this period. Understand that the exact amount and type of asset to be pledged is always decided upon during negotiations between the lender and borrower.
How Pledged Asset Work
This is used as collateral for a loan to get transferred to the lender from the borrower to secure the debt. Now ownership of the asset remains with the borrower during the loan period. Once the debt has been repaid, this is transferred back to the borrower. The lender can only assume ownership of the loan if the borrower defaults on the loan.
Why Does a Pledged Asset Matter?
It is seen as security by the lender because in the event of a default on loan payments by the borrower, a lender has something to fall back on. This why pledged asset loans often receive better interest rates as compared to unsecured loans.
The type and amount of pledged assets needed for a given loan is often a matter of negotiation between the lender and borrower.
Pledged Asset Mortgage
Homebuyers can sometimes pledge assets, like securities, to lending houses in order to stop the required down payment. When it comes to a mortgage, the house stands as collateral for the loan. Banks on the other hand will require a 20% down payment of the value of the note so that buyers don’t end up owing more than the value of their home.
Additionally, without the 20% down payment, the buyer has to pay a monthly insurance payment for private mortgage insurance (PMI). Without a down payment, the borrower may likely also have a higher interest rate. The asset pledged, can be used to stop the down payment, avoid PMI payments, and secure a lower interest rate.
As earlier stated, the pledged asset still remains with the borrower. The borrower keeps earning and reporting interest or capital gains on those assets. However, the bank retains the right to seize the assets if the borrower defaults on the mortgage. The borrower keeps earning capital raise on the pledged assets and gets a no-down-payment mortgage.
Advantages & Disadvantages of Pledged Asset Loan or Mortgage
Using pledged assets to secure a note comes with several advantages for the borrower as well as disadvantages. Let’s see them:
Advantages
- FIRSTLY, With pledged assets, a borrower can avoid large loan down payments and PMI if applicable.
- Secondly, The borrower keeps earning income and must report the gains from their investments.
- Thirdly, The borrower may receive a lower interest rate on the loan or mortgage.
- With a pledged asset loans, the borrower is allowed to retain ownership of the valuable possession.
- A borrower avoids tax penalties or capital gains taxes from selling the assets.
Disadvantages
- Where the pledged securities decline in value, the lender may demand additional funds.
- Pledging assets for the loans of a relative comes with default risk. Since there is no control over the borrower’s repayment.
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