“Neither a borrower nor a lender be.”
If the above quote from Polonius to his son, Laertes, in Shakespeare’s Hamlet is true, then being both the borrower and the lender might well be doubly foolhardy. But as a financial tool, it is worth knowing that most brokerage accounts allow the account owner to take out a margin loan and withdraw money from the account by borrowing rather than selling investments.
A margin loan can be useful when you have a short-term need for cash, with a high degree of certainty regarding the future cash flows you will need to pay the loan back. A classic example might be when the timing for a new home purchase and the sale of your existing home is off. You’ve bought a new home and need money for the down payment, but your current home is still on the market. If the sale proceeds are sufficient, they could be used to pay off the loan. Would borrowing against your investments be a good alternative in that situation?
As with most investing decisions, there are advantages and disadvantages. Let’s start with advantages:
- One of the biggest pros to borrowing from your account rather than withdrawing is you can remain fully invested and could potentially participate in long-term market appreciation. After all, that’s why we invest in the first place: to capture gains that occur in markets that rise over time. We invest and stay invested, through all kinds of markets, market conditions, and economic cycles. Because we can’t predict market returns, many investors choose a long-term approach
- Because you are not selling assets in your account, taking a loan may allow you to avoid realizing taxable gains that could result from a sale. If you are certain you’re going to put the money back in the account quickly, it might make sense to avoid realizing gains only to end up buying those same assets you just sold (and paid taxes for selling) a short time later.
- From an expense point of view, borrowing from your brokerage account might be one of the lower-cost sources of liquidity compared to other alternatives to access money. You may have a small savings from not having to sell securities in your account, but the larger savings, compared with other collateralized loans such as a mortgage or home equity line of credit (HELOC), is the absence of closing costs, that long sheet of seemingly endless expenses: application fees, processing fees, credit check fees, documentary stamps, title insurance, and many others. Anyone who has been through a house closing knows how those costs add up. With a margin loan, you have none of those expenses.
- And speaking of credit checks, when you’re borrowing from your own account, not only is there no credit check, but the amount you borrow from margin loans generally does not appear on your credit report in the same manner as traditional loans. As a result, margin loans may have little or no direct impact on a credit score.
Ready to open that margin account? Hold on! Let’s go over the drawbacks:
- Even though you are borrowing your own money, you still have to pay interest on the loan. And no, that interest doesn’t go to you. It goes to the custodian of your account (such as Charles Schwab or TD Ameritrade). And typically, the rates aren’t necessarily better, maybe even a little higher, than a mortgage or HELOC. Depending on interest rates and individual circumstances, a margin loan may be less expensive than carrying a credit card balance.
- You are permitted to borrow only a specific percentage, typically no higher than 50% of your account balance. If you borrow up to or close to the limit and the value of your account falls, you could be subject to a margin call, a demand from the lender that you immediately repay some or all of the loan balance. If you don’t have the cash on hand to meet the call, securities in your account will have to be sold. That forced sale might also trigger the realized taxable gains you were trying to avoid from Point #2 above. And yet another possible outcome of the margin call sale: You’re probably selling into a down market. That’s the most likely explanation for why you’ve gotten the margin call in the first place—a market downturn has caused a large decrease in the value of your account. A margin call may require the sale of securities at unfavorable prices, which could negatively impact investment results.
- Unless you’ve won the lottery and elected the annuity payout option, you can never be 100% certain of future cash flows. The example of “mistimed” home sales I gave at the open is a great case in point. You borrow money for the down payment on a home on which you’re about to close, and when you sell your home, you’ll pay off the loan. But anyone who’s been in that situation knows what the big, big risk is: You can’t be sure when you are going to sell and how much gain you’ll realize when you do. Even if you have an offer or a contract and a closing date set, anything can happen and often does. A buyer can fail to obtain a loan or get cold feet and crash your “quick loan” plan. The residential real estate market may be on fire now, but we’ve all seen those Zillow listings that have been up for months or even a year or more. If you end up in that situation, the loan hanging over your head may drive you to reduce the list price on your home for a quick sale rather than waiting to get top value, a decision that could cost you dearly.
- A margin account is not a formal loan contract and is subject to terms of the lending institution that can change at any time. This not only applies to the interest rate but the percentage you are permitted to borrow. If the interest rate changes, your debt service will rise. If the institution decides to lower the maximum loan percentage and not grandfather in existing loans, you could instantly be in a margin call even without a market downturn.
- Finally, whether on your credit report or not, debt is debt. A margin loan could decrease your net worth (depending on what you use the money for) and increase your expenses as you pay the debt service.
So, all of that leads us to a few key decision points in determining whether a margin loan is an option to consider:
- How much do you need as a percentage of the value of the account? Margin calls are driven by the value of the account you take the loan from. Any other investment accounts, including IRAs or other brokerage accounts, do not count in the calculation. You want that percentage of loan-to-account value to be as far from the maximum allowed as possible to allow for the possibility of significant losses to occur and still not trigger a margin call.
- How long will it take to pay back, and how certain are the future cash flows to pay it back? If you borrow $50,000 and feel comfortable that you have cash flow to repay $5,000 each month, you should have the loan repaid within a year. But as discussed above, the amount owed is certain. Future cash flows should be evaluated based on their reliability and the risks associated with those projections. If it’s income from your job, how stable is your income, your position, and your company? If it’s real estate income, how stable and “locked in” are your tenants? Imagine a worst-case scenario (loss of job, loss of tenants) and figure out if you have a backup plan to pay off the loan.
- What is your interest rate vs. expected return on money left invested? For example, if the anticipated investment return exceeds the borrowing cost, borrowing may appear more attractive from a mathematical perspective. However, investment returns are not guaranteed, and actual results may differ significantly from expectations.
One other factor to consider: This discussion pertains only to brokerage accounts such as taxable individual, joint, business, and trust accounts. You can’t take a loan from an IRA, and while some company-sponsored retirement plans such as a 401(k) might allow margin loans, there are big disadvantages to doing that, which we have discussed in past articles and, I’m sure, will address again in the future.
If all of this sounds like a lot—of course it is! And that’s why your Modera advisor is there for you if you want to have a discussion.
