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While we typically think of our investments as a form of wealth-building, they can also come in handy when we need cash fast.
Through what's called a portfolio line of credit (also known as a "margin loan"), investors can borrow against their taxable brokerage account at a moment's notice. In other words, an investor can use their stock holdings and other investments as collateral for a loan while their money stays in the market.
David Totah, CFP and partner at Exencial Wealth Advisors, calls borrowing against one's brokerage account "one of the very best sources for short-term financing," which he defines as three to six months. But taking out a line of credit where the loan relies essentially on the market's movements can have its cons as well. Here's what to know to decide if you should make the move.
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With a portfolio line of credit, an investor can score a lower interest rate than they would taking out a traditional loan or when using a credit card since their investments act as collateral, therefore signaling to the brokerage a lesser chance of default.
Take, for example, the robo-advisor Wealthfront, which allows investors to borrow up to 30% of their portfolio in 30 seconds, its website says. Rates range from as low as 3.15% to 4.40% APR, and money gets deposited into your bank account in as little as one business day. M1 Finance offers rates even lower at 2.75% to 4.25% APR, and investors can borrow up to 40% of their portfolio's value with access to funds in M1 accounts in minutes and available access in one to two business days in external banks, its website says.
Since there is less risk for the broker, qualifying for a portfolio line of credit is generally easier to do than it is with other loans.
Borrowers also have greater flexibility when repaying their loan as there's no set repayment schedule. You can simply repay on your own terms or schedule recurring payments, and there are no minimum payments or early payment penalties. Interest is added to your balance each month.
Portfolio lines of credit give you access to your investment money without triggering the usual capital gains tax since you borrow against your positions without having to actually sell. For this reason, Tony Molina, a CPA and senior product specialist at Wealthfront, suggests borrowing against your portfolio as opposed to selling investments when you want to pay off high-interest debt.
"If you're paying 20% interest on credit card debt and can take out a line of credit on your investments for 4%, you're saving 16% in net interest expense," Molina explains. "In this case, you would absolutely want to consider a line of credit. However, if you're considering using a line of credit at 4% to pay off debt that's only a bit higher than 4%, say 6%, that savings may not make much sense."
Sara Kalsman, a CFP at Betterment, says that she commonly sees lines of credit used for "bridge financing." This is when individuals use a line of credit to help fund, for example, a down payment on a new home while in the process of selling their existing home.
"Make sure you are in a position where you'll be able to make monthly payments for an extended period of time from available cash flow if needed," she adds.
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Brokerages will extend a certain amount of credit based on the value of the investor's portfolio. But keep in mind that the value of your investments, or the underlying collateral in this case, fluctuates with the market. So, a volatile environment could have negative repercussions and you could end up actually owing a lot more than you first borrowed.
If your portfolio value declines below a certain threshold, triggering what's known as a "margin call," you may be required to deposit additional funds (aka add more collateral) or sell a portion of your portfolio to repay some of the loan.
Keep in mind also that the interest rate on a portfolio line of credit is not locked, meaning that the rates can go up or down at any time. Having a variable interest rate can come in handy in low interest rate environments, but it hurts you when interest rates go up.
"This is a considerable risk to evaluate when taking out a line of credit during today's rising rate environment," Kalsman says.
Totah agrees: "For the past several years, the interest rates on these types of loans have been very attractive, though most recently rates are going up," he warns. "In a rising rate environment, this type of loan could get more expensive as rates increase."
Using a margin loan to invest more, or buy additional securities, also carries its own risks, as your potential portfolio losses will be magnified.
Taking out a line of credit from your investment portfolio could be a smart idea in a low interest rate environment, especially for short-term financing needs. Make sure, however, that you have a payment plan in place to pay down the loan in reasonable time and that you are not over-leveraging yourself. While you may be able to borrow as high as 50% to 60% of your total portfolio value, experts advise against going that high. Have a clear understanding of what the line of credit will be used for before making the move.