Lesson 19 of 20 · 7 min
Auto-pay from a pledged account, and the feedback loop
Paying interest out of the collateral shrinks the collateral, and the amount sold is largest in the worst markets.
Interest has to be paid from somewhere. If it is paid automatically from the pledged account, the payment consumes the very thing securing the loan, and that creates a loop worth tracing carefully.
There are two ways to service the interest and both reduce headroom, through different channels. Capitalising it raises the balance, which raises the trigger value. Auto-paying it from the pledged account holds the balance flat and lowers collateral value. In a flat market the second is generally the gentler of the two, and in a falling market it has a property the first does not.
The property is this: the interest payment is a fixed dollar amount, so meeting it by selling securities sells more shares when prices are low. That is reverse dollar-cost averaging, and it operates automatically, monthly, without any decision. In a prolonged decline it converts a fixed obligation into an accelerating consumption of shares.
There is a further step in the loop. Each sale reduces collateral, which reduces headroom, in the same market that is already reducing collateral through prices. The two effects compound, and unlike a price decline the sale is permanent — those shares do not participate in a recovery. If the sale happens to occur while the account is near its threshold, it is a small forced sale occurring on a schedule.
The loop is not a defect in auto-pay, which is convenient and prevents missed payments. It is a consequence of the funding source, and it is only visible if you trace where the cash comes from.
Key terms
- Auto-pay
- Automatic debiting of interest, often from the pledged account. Convenient, and it consumes collateral if funded by sales.
- Reverse dollar-cost averaging
- Selling a fixed dollar amount periodically, which sells more shares at low prices than at high ones.
- Feedback loop
- A mechanism whose output feeds its own input. Here, sales reduce collateral, which reduces headroom, in the market already reducing both.
Worked example
Three years of interest, two funding sources
Collateral $600,000, balance $300,000, threshold 70%, rate 7%. Compare capitalising against auto-pay funded by sales. Flat market.
- Capitalise: balance after 3 years
- $367,513
- Capitalise: trigger value, headroom
- $525,018, 12.5%
- Auto-pay: balance after 3 years
- $300,000
- Auto-pay: collateral sold
- About $63,000
- Auto-pay: collateral, headroom
- $537,000, 20.2%
- In a 30% decline, shares sold to raise $21,000
- 43% more shares than at the starting price
$300,000 × 1.07³.
Trigger stays $428,571.
Three years of interest.
Auto-pay preserved eight more points of headroom in a flat market, and in a declining one it sells 43 percent more shares to raise the same cash.
Check yourself
Interest is auto-paid from the pledged account by selling securities. What happens in a prolonged decline?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.