Fidelity generally suggests keeping $1,000 or 3 to 6 months' worth of living expenses in a liquid account that can be used for emergencies, and the rest of your savings invested in a diversified portfolio. However, what if an opportunity arises that would require liquidity beyond the amount of ready cash you keep on hand?
Perhaps you've taken a new job, which requires a move to another state. During a visit to your new town, you find the perfect home—but with your old home not yet sold, you don't have the funds available in cash for the down payment. Maybe you're waiting for the paperwork to clear from an inheritance or planning for a bonus you'll receive later this year—but you have the opportunity to purchase a small business or beach house now, and if you wait, it'll be too late.
One option might be to sell securities to cover the cost. Doing so, you might incur substantial capital gains taxes—and lose the opportunity for potential future growth of the assets. Another option is to borrow against the value of a hard asset, usually your home, or a portfolio of securities. Borrowing against assets can offer potential benefits including a minimal or streamlined application process and the potential for favorable interest rates. While you'll pay interest on the loan, you can weigh that cost against the potential growth you might see from the assets you'd otherwise sell, adds Michael Mariani, vice president of lending solutions at Fidelity. Borrowing against your assets may also come with additional risks, since the assets need to maintain a certain amount of value for the duration of your loan. "In general, this type of leverage should be used when you're confident you can repay the loan quickly,” says Lou Gentile, advanced planner at Fidelity.
Below are 3 ways you might borrow against your assets, and some of the potential benefits and considerations of each.
Home equity line of credit (HELOC). This is a line of credit backed by a residential property that already has a mortgage on it, usually your primary home. A HELOC works a bit like a credit card in that you generally are given a maximum amount you can draw on based on your home's market value and current mortgage's first mortgage balance (say, $150,000) for a fixed period, which is most often 10 years. You only pay interest on the amount you borrow until the fixed repayment period ends, and interest rates on HELOCs are generally well below that on credit cards. Interest payments on HELOCs are generally not tax-deductible, unless you are using the funds to build or improve the home that is backing the loan.
HELOC considerations: These are generally floating or variable-rate loans, which means your borrowing costs could rise especially in a rising-interest rate-environment. You'll need to apply for the loan, which could take several weeks to process, and there may be application and ongoing fees. Should you fail to make payments, your home could be at risk.
A line of credit against your investments. Instead of being backed by your home, a securities-backed line of credit is backed by assets in an eligible taxable brokerage or professionally managed account. You may be able to borrow as much as 70% of the total amount of your portfolio, depending on the total amount you own and what you're invested in, and unlike many HELOCs, there are typically no annual fees. In addition, the application process can be minimal, and you can usually obtain your loan within a matter of days. Rates are typically comparable or a little lower than the rates on home equity loans.
Line of credit considerations: Like a HELOC, this is a variable rate loan. You also can't use line of credit funds to buy investment securities, or repay another margin loan. In addition, there is market risk; should the assets in the account fall below a certain value, you'll need to pay down the loan immediately, or the assets may be sold. Borrowing against a well-diversified portfolio of assets and limiting the amount you borrow in relation to the maximum available line can potentially reduce the risk of the account balance falling below the minimum required. In addition, certain features of your account may be restricted, and if you fail to repay your loan, the bank may seize your account.
Margin loan. This type of loan is also backed by your investments and is typically used by active traders to buy more securities. The amount you can borrow varies depending on the investments you hold, but it is typically 30% to 50% of your total portfolio.
Margin loan considerations: Margin loans typically come with a maintenance requirement, or the minimum value that your account needs to retain after you've used the funds. Should the value of your securities fall below the maintenance level, you'll need to immediately deposit more money in the account, or your brokerage firm may sell your stocks, which could potentially trigger capital gains.
The bottom line
Leverage can be a powerful option to help you achieve your short- and long-term financial goals, but it can also be risky. A financial professional can help you think through the considerations and determine a strategy that makes sense for your family's needs, assets, and long-term objectives.