Don't let the strong stock market whet your appetite for more risk — as in borrowing against your brokerage account.
The first five months of 2016 have been good for the S&P 500, which closed on the first day of May at 2,388.33, just shy of it's all-time high of 2,400.98.
Because equities have been faring so well, more investors are considering margin loans. These loans allow you to borrow up to a specified amount of your account's value without having to sell your holdings and generate capital gains.
You're assessed interest on the loan, which can be as high as 8 percent and may be charged daily or monthly, depending on the brokerage firm. And none of this is risk-free.
Once you take out a loan, your brokerage firm will require you to keep a minimum balance in your account. If the market tanks and the value of your investments declines sharply, your account balance could fall lower than the required minimum.
In that case your brokerage firm could make a margin call and you may have less than 24 hours to deposit cash into your account or else your firm may sell some or all of your assets at its own discretion.
An example of how a margin loan works:
Let's say you take a $30,000 loan from your $100,000 brokerage account.
Shortly thereafter, the market drops by 50 percent while you still owe the full amount you borrowed. At this point, your portfolio is only valued at $50,000, and you are on the hook for the $30,000 loan.
Your remaining stake in the portfolio in this case is $20,000. At this point, the brokerage may require you to put up more cash or they may sell your remaining holdings.
"The time will come: The markets will come down," said Allan Katz, founder of Comprehensive Wealth Management Group in Staten Island, New York. "Long term, that's not terrible, but on margin, it's a disaster."
A new entrant to margin
Wealthfront, a robo-advisor that manages over $6.1 billion, recently announced it will allow its investors to borrow against their portfolios.
Clients with at least $100,000 can borrow up to 30 percent of their account value and pay 3.25 percent to 4.5 percent in interest, which accrues monthly.
Wealthfront dubs this new offering a "portfolio line of credit."
The firm said its typical client is 32-years-old and those young investors may need short-term funding for milestones such as buying a home or financing a wedding.
"We looked at why people made partial withdrawals from their accounts," said Kate Wauck, head of communications at Wealthfront. "Much of it is to buy a car or for a down payment — short-term liquidity needs."
It doesn't take long for clients to access their loan: They can tap their portfolio online through their smartphones and in most cases get their money in 24 hours.
Think before you borrow
Thomas Yorke, principal of Oceanic Capital Management in Red Bank, New Jersey, recalled seeing margin loans go horribly wrong in the run-up to the 2000 tech crash.
At the time, investors borrowed against their portfolios to make speculative stock purchases.
They were burned when the market tanked, their account balances plummeted and brokerage firms demanded repayment.
"In one case, it went so far wrong this guy had to massively liquidate his positions, and it was done on a day that wasn't market friendly," Yorke said.
These days, investors might be inclined to use a margin loan as "bridge financing," funding a down payment if they're in between selling their home and buying a new one.
Even in this case, risks abound. What if you find your dream home, but the house you currently own doesn't sell as quickly as you anticipated?
It happened to a client of Russ Weiss, a certified financial planner at Marshall Financial Group in Doylestown, Pennsylvania. In this case, the investor borrowed close to 50 percent of his portfolio value and would've faced a margin call if the market fell by just 10 percent.
The client was getting nervous because a year went by and the house still hadn't sold — and the loan was still outstanding.
"It puts them in a bad position," said Weiss. "They've lost their negotiating power for selling their house, and now they're more inclined to accept an offer."
To clear the decks of the margin loan and shake off the cost of owning two dwellings, the investor lowered the price on his house to speed up the sale.
Manage risk
Margin loans are risky, but they don't have to ruin your finances if you use them conservatively. Financial advisors recommend that they be used as short-term financing only and with the following guidelines.
- Consider why you're tapping these funds: Ask yourself if you can repay the loan within six months at the most. If you're looking for some cash to get you from the sale of one home to purchase another, consider how long it'll take you to sell your house.
- Borrow below the maximum: Just because you can borrow 30 percent, 40 percent, or even 50 percent of your account, doesn't mean you should. Weiss recommends that borrowers tap no more than 20 percent of their portfolio value. Never forget that a sharp downturn will imperil your account.
- Weigh your other options: Can you tap other sources of quick cash? A home equity line of credit (HELOC) may make a good source of quick funds, and the price of your home is probably more stable compared to the stock market.