Occasionally, I am asked to meet short-term funding needs. Often this involves planning the sale of one property with the purchase of another. For example, if the closing dates overlap for a period when buying a home, a shortfall may arise, requiring additional capital. The traditional approach to this shortfall could be a traditional bank loan, using existing cash savings, or perhaps withdrawing from an investment account. There is a potential workaround that could prove to provide additional benefits, if implemented with caution.
Borrowing on margin involves borrowing from your own investment accounts without selling any of the investments. Some custodians offer this feature on non-retirement accounts. IRAs, Roth IRAs, and 401ks are not eligible for this type of borrowing. Like traditional loans, margin loans have an interest component that applies to the outstanding loan balance. Often these borrowing costs are tied to the current prime rate, which is heavily influenced by the current Federal Reserve funds rate plus an additional amount.
Compared to traditional loan underwriting, margin loan can be completed faster. Used in the right situation, margin lending can offer an attractive alternative as you can borrow money at a relatively low rate without disrupting an investment portfolio, which may have returns that exceed costs. If the need for additional funds is short-term, borrowing on margin could also generate potential tax benefits. Rather than selling portfolio investments and realizing potential capital gains, margin borrowing avoids any disruption to the historical cost base. You can repay margin loans over time through dividends or interest earned in the portfolio, periodic bank cash payments, or paying the full amount all at once when you receive payment from an outside transaction .
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Keep in mind that margin borrowing is subject to certain limits and risks. Many custodians who offer this option limit the loan amount to fifty percent of the eligible account balance. Since investment returns can vary widely over a short period of time, it is generally prudent to borrow only a portion of the available amount. The investment performance of the portfolio could cause the outstanding margin balance to exceed the maximum level. If this were to happen, the custodian could sell part of the portfolio to repay the balance until it falls below the maximum threshold.
Consulting your financial and / or tax advisor is an essential first step if you are considering margin financing. Remember that plans are always subject to change, and short-term financing needs can turn into long-term needs if the unexpected happens. Make sure you have other contingencies in place if they become necessary.
Ruedi is a financial advisor at Savant Wealth Management, Bloomington.