Tuesday, October 17, 2023
Anthony C. Kure, CFP®

Anthony C. Kure, CFP®

Managing Director of Northeastern Ohio Market, Senior Portfolio Manager, Principal
Management Team, Wealth Management Services, Cleveland - Akron

The Very Limited (But Useful) Case For Margin Borrowing

On the 25th anniversary of the failure of the famous hedge fund, Long Term Capital Management (LTCM), we can think of no better example of the dangers of using debt to finance speculative market bets.

For those who aren’t familiar (or don’t have much grey hair to remember it), LTCM was a famous hedge fund that collapsed in the fall of 1998 under the weight of an enormous amount of debt, which fueled their 40%+ annual returns. By the end of their run in September 1998, however, they held a leverage ratio of about 250-to-1, which means they had capital of about $400 million but assets of about $100 billion, according to a recent Bloomberg story. When everything is going up, it’s not a problem, but when “bets” turn sour, that type of leverage can bring an investment house crashing down quickly.

While the rise and fall of LTCM is the case study in large-scale leverage gone bad, many people on a smaller scale employ essentially the same tactics and suffer the same consequences, by borrowing against their assets “on margin” to speculate on what they are confident will be a positive investment outcome. The operative word is “speculate” because these folks aren’t looking to purchase a security based on fundamentals, such as attractive relative valuation to peers or strong free cash flow. They are simply looking to buy with the intention of selling to the “next person” at a higher price in the next month, week, or day. Very often, they borrow money on margin to super-charge their potential returns, with the intention of paying back the loan after they’ve sold at a profit.

For prudent investors and most of our clients, this tactic is not one we employ when constructing an investment portfolio and wealth plan on which a family is expected to depend for decades and beyond. However, borrowing on margin can, in select cases, be a smart move financially when used correctly, cautiously, and in very limited circumstances.

How Margin Borrowing Works

Borrowing on margin is simply borrowing cash to finance a purchase, and the collateral is the value of the investment account. Like any loan, the borrower pays an interest rate on the borrowed funds. The firm that supplies the cash is a custodian of these assets (e.g., Charles Schwab, Fidelity, etc.), and the amount available to borrow is based on some percentage of the assets held, usually stocks and bonds. Given the historic differences in the short-term volatility of stocks vs. bonds, firms usually allow a higher borrowing percentage of fixed income compared to equities. In addition, most firms limit the borrowing to taxable accounts only (not retirement accounts like IRAs) because they don’t have the same tax and penalties associated with withdrawals. In general, borrowing is limited to 50% of marginable securities. If the underlying account value is stable or goes up, the custodian obviously doesn’t require outside funding to maintain the required level. However, if the underlying account value goes down, then the dreaded “margin call” comes in, which requires outside funds to backstop the value of the depleted collateral. This dynamic has been the downfall of speculators dating back to the Dutch Tulip Bubble in the mid-1600’s.

When It Can Make Sense

With all these warnings and caveats noted, we think borrowing against one’s assets for short-term funds for a home purchase can make sense. The most common scenario is to provide “bridge financing” in that unsettling time between purchasing a new home and selling an existing home. Especially in today’s still-competitive housing market, being able to buy a home with a cash offer is a distinct competitive advantage. Most people don’t have hundreds of thousands of dollars of cash lying around, especially when they haven’t sold their existing home yet. This is where margin borrowing can help: With the margin loan, a person can borrow the cash, buy the new home, pay interest on the margin loan for a month or two (hopefully), and the loan is repaid in full when their old house sells.

Doing the Math: Interest Expense vs. Capital Gains

The key advantage to this strategy is to avoid having to liquidate stocks and bonds in a taxable account and incurring capital gains taxes, which can be as high as 23.8% federal on long-term capital gains and ordinary income rates (up to 37% federal) on short-term gains.  Once you add in potential state tax, liability to the government can add up very quickly.

Here’s the math: let’s say a person wants short-term financing on a $400,000 home purchase, and they will sell their old home for $350,000. The market rate for margin loans (as crazy as it sounds now) is around 8%. (Note: this can fluctuate based on the custodian and the level of assets held at a firm). Interest expense in this case for two months would be about $5,333. ($400,000 x 8% / 12 x 2 months). Certainly not the cheap money we’ve grown accustomed to. Then, compare that to selling $400,000 securities with a conservative cost basis of $300,000 for a long-term capital gain of $100,000. The tax bill on that can be as high as $23,800 assuming it’s all long-term gains! In addition, the higher capital gains income can result in collateral tax damage, such as more tax on Social Security and potentially higher Medicare premiums (due to IRMAA: income-related monthly adjustment).

So, borrowing on margin for a very short-term to purchase a home and then paying the loan back can save a family thousands or even tens of thousands of dollars if executed properly. Of course, a thorough analysis of potential capital gains and a tax projection is highly recommended.

Bottom Line

For a family’s long-term wealth plan, limiting or eliminating debt is certainly a prudent approach we fully endorse in general. Buying on margin is a dangerous game played by fast-money hedge fund types and meme-stock speculators, and it’s a game we don’t support or recommend. But in select cases, with a clear line-of-sight to a quick loan payback and limited time to endure underlying market fluctuations, a borrowing on margin tactic can make a lot of sense. In many cases, a few months of interest expense, even at today’s higher rates, can be much lower than the potential capital gains taxes associated with liquidating low-basis investment holdings.