Many investors are not even aware they can borrow against a portfolio, much less the implications of doing so. This tool can be a saving grace or a wrecking ball when it comes to your assets. So, could it help you? It all depends on the timing and the conditions.
How Does a Margin Loan Work?
As a general rule, individual investors are able to margin their brokerage account and borrow as much as 50 percent of the value of the assets in the account. But, brokerage firms can have different policies, and the amount you can borrow is based on the type of assets you own.
Riskier assets may offer lower borrowing amounts than more conservative assets. In this scenario, you can take your cash out as a loan or keep the cash in the account and use it to purchase more investments. The borrowing rate (margin rate) can vary, but if the additional investments outperform the costs of the loan, you could earn greater profits.
One thing to keep in mind: The margin rate you are quoted might be negotiable, particularly if another borrowing option has a better rate. Always ask for more competitive rates. Your brokerage firm might not budge, but it doesn’t hurt to ask!
When Might Margin Loans Pay Off?
Going the non-traditional route by borrowing against your brokerage account and using the cash for a non-investment purpose can be a useful strategy. For example, it can prevent selling appreciated assets to fund a temporary need. And, that means you’ll avoid incurring capital gains taxes.
Some situations where it may be worth it to borrow from your brokerage account include the following:
- Bridge loan for home construction until a traditional mortgage can be put in place
- New home purchase while you’re waiting for your existing home to sell
Tax Treatment of Margin Interest
Another consideration is that your margin rate might be low enough that borrowing against your investments is cheaper than a traditional mortgage or home equity loan – particularly since it isn’t as easy to deduct interest from home equity loans as it was last year.
And here’s a tidbit you may not have thought about: The interest charged on a margin loan can offset income earned in your portfolio, making the interest indirectly tax-deductible. Please consult your tax advisor before making any decisions based on the tax deductibility of different loans.
As mentioned earlier, you can invest borrowed money within your account, thus leveraging the investment(s). If your investment outperforms the cost of borrowing the money, your portfolio gains some extra profit.
Here’s an example: Let’s say you borrow $250,000 at 6 percent on a $500,000 account and invest the loan back into the same investments. If you earned 10 percent, the gross return would be 12 percent, or an extra $10,000 versus your non-margined account.
That sounds good, right? But keep in mind that your losses also amplify.
In the example above: If you earned 30 percent or lost -30 percent, your gross returns would be 42 percent and -48 percent, respectively. If you want to get back to even after losing -48 percent, you must earn 92 percent going forward!
Caution Is Your Friend
Brokerage firms are very careful not to lose money on a margin loan. The assets in the account are used as collateral for your loan. If the value of your investments falls below the amount of the loan, you could walk away from the loan leaving the brokerage firm under water. To avoid this, brokerage firms will make “margin calls”. When the value of your loan reaches a specific threshold, say 70 percent of the account’s investment value, the brokerage firm will force you to sell assets and pay down a portion of the loan. If you don’t act quickly enough, they will sell the assets of their choosing, which may or may not match your desires.
Selling assets as they are going down is generally not a recommended investment strategy. Not only are you losing money in your portfolio and enduring a borrowing cost, you are potentially selling assets at exactly the wrong time and limiting the ability of your portfolio to recover.
This article isn’t meant to scare, but if you feel skittish, then I’ve met my goal. Margin loans can be useful, but when they are used for simply leveraging an account to juice the returns, margin loans can be risky.
Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.