Need Cash? A Margin Loan Might Be the Answer
Margin is a way to borrow money from your investment account rather than going to a traditional lender. Of course, the money must be paid back as the custodian is essentially providing the loan, but it can be a much cheaper and operationally easier way to access cash. Whether needed to purchase a new home (possibly while you are waiting to sell your existing home), purchase a second home, pay tuition, buy a new car, or any other large expense, margin can be your best option. For institutional clients, it may be a good way to fund short term operational expenses.
With mortgage rates now above 3% and climbing, it may be cheaper to use margin to finance a home purchase in some circumstances (clients of Innovest have consistently been obtaining margin loans below 2.0%). Getting a traditional mortgage involves significant paperwork and the process can take weeks. On the other hand, using margin typically involves signing an agreement between you and your custodian; there is no income verification or the need for all the other documentation typically required to obtain a mortgage. In most cases, you can allowably borrow up to 50% of your investible assets but note that should the market decline while you are margined up to that 50% threshold, you would need to make a margin call (add money to your account) to get back below that 50% limit.
Keep in mind that because margin loans are based on a spread over the Federal Funds rate, their interest rate can float up or down depending on what actions the Fed takes on interest rate policy.
With a traditional mortgage, the homeowner typically must pay monthly principal and interest. With a margin loan, a borrower only pays interest monthly; you are free to pay back the principal any time you like. For individuals, from a tax standpoint, a traditional mortgage and a margin loan may provide for tax-deductible interest payments. In other words, you may be able to deduct the interest you pay from your taxable income*.
Below is a summary of the considerations when weighing a mortgage vs. a margin loan.
Of course, margin can be used for needs other than the purchase of home. There are essentially no restrictions for the use of the borrowed funds.
For institutional investors, margin can be a great way to address short-term cash flow needs, as all the benefits described above apply -- minimal paperwork, lack of a requirement to produce financial statements, efficiency of obtaining funds, interest-only payments, principal payback when convenient, and so on.
For investors who need liquidity and do not want to incur the tax liability of selling assets to raise the cash, margin is a suitable tool. For example, if someone needed $200,000 in cash and did not use margin, they would have to pay capital gains taxes on their investments sold. Short-term capital gains are taxed at ordinary income rates, so for high earners, this could be as high as 37%. Long-term capital gains rates are taxed at 20% (both figures exclude state tax rates), so raising cash through the sale of assets can be expensive.
As a simple example, suppose an individual with $1mm in a brokerage account needed $200,000. Assuming no investments in the portfolio would be sold at a loss, liquidating $200,000 of assets would incur a tax bill of $40,000 ($200,000 x 20%). Now assume that same individual took out a margin loan for $200,000 at 2%, the annual interest expense would be $4,000 ($200,000 x 2%). In essence, the breakeven point would be 10 years. Additionally, because the $200,000 would still be invested in the portfolio, it’s likely that a diversified moderately invested portfolio would earn more than the 2% interest being paid on the margin loan, so the account value would continue to be fully invested and appreciate. Had the individual sold $200,000 of assets, the portfolio would only have $800,000 invested vs. the $1mm under the margin loan scenario. If the portfolio earned an average of 5% per year, that $200,000 would generate $10,000 ($200,000 x 5%) of appreciation, more than enough to cover the $4,000 interest expense and allowing that investor to pay down the margin loan at their convenience.
For institutions, using margin can decrease the transaction costs of having to raise cash. The portfolio remains fully invested, so the long-term objectives of the portfolio can be met with minimal drawbacks. If the interest rate on the margin (cost) is below that of that of the return objective of the portfolio (e.g., 5%), using margin may be a great way to access cash for short-term needs.
If you need a cash outlay and are weighing various options, using a margin loan on your investment account should be one of your considerations.
* Please consult your tax advisor for tax advice.