How to Use Tax-Exempt Municipal Bonds As Collateral

Understand what happens to your bonds if you can't repay loans.

Understand what happens to your bonds if you can't repay loans.

Many lenders view municipal bonds as a sound investment because they're backed by state or city governments. These bonds pay interest that is tax free at the city, state and sometimes federal levels. Sound financial backing and tax-free earnings make municipal bonds attractive to banks when a borrower presents these bonds as collateral. You can use bonds as collateral if you follow certain procedures.

Verification of Ownership

Prepare any proof you have that the bonds belong to you. For example, you can present a monthly statement from your broker as proof that you own the bonds. A broker typically holds the certificates, which proves you own the bonds but allows the broker to trade them on your behalf. Your broker can provide the lender with proof that he is holding the certificates. You can also present the bond certificates themselves if you have them.

Possession of the Bonds

If you have the physical bonds, you can transfer them to the possession of the bank to hold for the term of the loan. If the bonds are located elsewhere, the bank can place a lien on the bonds. This lien gives the bank the right to sell the bonds if you are unable to pay back the loan. If you don't pay back all of the loan and the bank sells your bonds, you are entitled to any proceeds from the sale beyond the full payback amount of your loan.

Borrowing Eighty Percent of Valuation

Calculate the loan amount you qualify for by multiplying your bond value times 80 percent. Most banks will only loan 80 percent of the value of any collateral, and this is especially true with municipal bonds because they run the risk of losing value. If you can accept less than 80 percent of your bond's value, let the lender know. This could make your loan more attractive to the bank.

Bond Rating

You should check your bond rating before pledging it as collateral. Many ratings agencies, such as Moody's and Standard and Poor's, rate municipal bonds based on their creditworthiness. You can check with your bank to see what the minimum rating is for bonds it accepts as collateral. Note that bond ratings are subject to change. If your bond's rating drops after the loan has been made, the bank may reserve the right to renegotiate the interest rate on the loan to compensate for the higher risk.

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