You may have heard of buying on margin.
Once reviled for fueling the Great Depression, this risky practice allows investors to borrow money against their portfolio to purchase additional investments.
But there’s another way to use margin.
In the same way a bank can lend you money against your home equity, a brokerage firm can lend you money against the value of your portfolio’s stocks, bonds, and mutual funds.
This margin loan can be an effective tool to meet short-term financial needs.
How Do Margin Loans Work?
Margin loans work for any situation where you have a significant expense today, but not the cash to cover it for another six months to a year.
Brokerage firms follow certain guidelines to determine which stocks, bonds, and mutual funds are marginable. Most securities traded on the major U.S. exchanges generally fit the bill, but assets held in retirement accounts are off limits.
Generally speaking, 40% to 50% of the account value can initially be borrowed. An investment account worth $2,000,000 that is invested in a diversified portfolio, for example, could provide $800,000 to $1,000,000 in borrowing capacity.
What Do Margin Loans Cost?
There is no cost to set up a margin account, and the balance can be paid off at any time with no pre-payment penalty.
Much like a home equity line of credit, rates for margin loans are variable and are tied to the Federal Funds rate (currently 2%). A “spread” is added to the Fed Funds rate to arrive at the ultimate margin rate.
One advantage of managing close to $1.5 billion in assets is that we can negotiate very favorable margin rates for clients.
A Case Study
Earlier this summer, Joe and Barb found their dream home. It was listed at $800,000. Given the competitive real estate market, they wanted to make a full cash offer not contingent on the sale of their existing home. Their plan was to sell their home for $600,000 after they’d moved into their new digs.
In anticipation of this purchase, they squirreled away $200,000 in savings but needed to come up with the balance to cover the cost of the new home.
Rather than liquidate $600,000 in portfolio securities, we recommended they borrow against their portfolio using margin.
While borrowing against their portfolio did incur the cost of the margin loan, it had the benefit of avoiding the sizeable capital gains tax—$36,000 in Joe and Barb’s case—liquidating securities would have otherwise realized.
Borrowing on margin also kept their portfolio intact, preserving the expected earning power of that $600,000.
In the end, Joe and Barb were able to make a contingency-free offer and closed on their dream home. Three months later, their old home sold and they deposited the $600,000 in proceeds, paying off the margin balance.
During the three months it took to sell their previous home, they incurred margin costs of $7,500. They found that an acceptable price to pay for avoiding the much larger tax bill realized gains would have produced.
An Option to Consider
Using margin not as a trading tool but as a cash management tool can be a savvy way to fund short-term needs, minimize tax implications, and maximize savings.
By understanding your short-term cash needs and unique circumstances, Vista can thoughtfully help you select the right tool in your tool belt.
If you have questions or would like to discuss your options in greater detail, contact Vista.
