Passive Income with the E*Trade Fully Paid Lending Program?

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An interesting offer landed in my inbox the other day from E*Trade. The email claimed that with just a few clicks, I can agree to let the firm lend out some of the shares I may own now or in the future for an estimated $671 a year in passive income. With the E*TRADE Fully Paid Lending Program, they are basically promising me free money for doing nothing different. Is this too good to be true? What is the program even about?

I did a little digging.

Securities Lending Isn’t New

Borrowing securities is as old as shorting the market itself. That’s because when you short the market (bet that the market goes down), you put up collateral to borrow shares you don’t own that track the market just so you can pay them back later. And while you are borrowing these shares, you also have to pay a borrow fee much like paying interest on a loan.

With the Fully Paid Lending Program, E*Trade is using shares that you own to lend out to other traders who want to short the security and sharing that income with you.

E*Trade Isn’t the Only Game in Town

Fidelity, Charles Schwab, Interactive Brokers, and even Ally Invest have similar programs. Ally calls its offering the Securities Income Program, while Interactive Brokers call it the Stock Yield Enhancement Program. The other three call it a Fully Paid Lending Program. I imagine the name was picked because all the firms want to highlight the fact that your lending is backed by collateral that’s at least 100% of the value of the borrowed shares. This means that in the event that the borrower runs into financial trouble and they cannot return your shares, you still have the collateral to cushion the event.

Is The Fully Paid Lending Program Worth It?

The benefit is straightforward, but what are the risks? Here are a few to consider before you jump in with both feet.

There’s no SPIC Insurance – This is the biggest risk. If I sign up with E*Trade and the firm was to run into financial trouble, the shares I lend out through the institution aren’t covered under the Securities Investor Protection Act of 1970 (SPIC insurance). I should still be able to get the collateral back if something goes terribly wrong, but that amount may be substantially lower than what the shares are worth if the value of the shares moves significantly higher since they were lent out.

Dividends are paid “cash in lieu” – Under current tax law, qualified dividends receive preferential treatment. In other words, the income is taxed at lower rates. If a dividend is paid for any shares that are lent out, the dividend received will be credited to the account as “cash in lieu” and do not qualify for preferential treatment. This means that all dividends could be taxed at ordinary income tax rates.

You have no voting rights – Most people don’t vote so this is moot, but you lose your voting rights anytime the your shares are lent out.

You May Already Be Benefiting from Securities Lending

The funds you invest in already lend out the shares they own and thus you may have been making income through the scheme all along. What’s unclear is whether mutual funds share that revenue stream with their investors. At least Vanguard, which is completely client-owned, shares that revenue with its investor base.

For example, I invest a bulk of my assets in the Vanguard Total Stock Market Index ETF (VTI). They reported that the fund made $170.44 million through securities lending in its latest prospectus. Now for a fund that tops $1 trillion in assets, $170 million is just a chump change. Still, money is money. $170 million is still $170 million more in the investor’s pocket instead of some corporation. Your fund may or may not make more with stocks it owns, and they may or may not share it with you. If you are interested, you should look into its prospectus to find out.

So What’s the Verdict?

There are risks involved, but I’m tempted to accept the offer and see how it all works. For one, I see the chances that E*Trade runs into serious financial trouble while my shares are being loaned out AND that they are unable to reclaim my shares as extremely low. Plus, I don’t see losing my voting rights as a deal-breaker. The only hiccup I see is the cash in lieu payment instead of qualified dividends. That’s why I’m only interested to apply for the lending program with a tax-advantaged account. That way, I won’t have to worry about whether the income I receive will make up for the loss of lower tax rates on dividend payments.

I received the offer in my inbox, but this is hardly an invitation-only program. You can apply for the program at any time through the various brokerage firms. What do you think? Are you tempted too?

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  • KC says:

    The hedge funds use your loaned shares to SHORT the company you invested in.
    Foolish move to sign up for this stock lending program.
    You are sabotaging yourself.

    • David @ says:

      I can see your point but then people will short the stock no matter if you lend to them or not. There are plenty of places that will lend out shares (even mutual funds lend them out) so not lending yourself won’t make a difference to the short seller’s ability to bet on the moves.

  • George says:

    Currently making $1,034 per day in all 4 of my accounts by lending out my shares. It is literally a dream.

    • David @ says:

      Wow, that’s quite a bit. Do you mind sharing what kind of stocks you are invested in? I haven’t signed up yet and honestly forgot about this after I wrote about it, but you definitely perked my interest in the program again!

  • Oh boy says:

    I’m running program now. Not every stock is borrowed and some get returned and borrowed again. It’s free money. What’s not to like?

  • Zoom Dickson says:

    There’s a reason why these programs aren’t that popular. Why would anybody choose to get their dividends taxed at a higher rate just to make a few pennies?

  • Vicki says:

    No SIPC insurance is a non-starter for me. $671 is nice but it’s not that nice. That’s like one day of gains!

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