Borrowing Like a Billionaire

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Forget lemonade stands and paper routes – the uber-wealthy have a different way to raise cash.

During my earlier days working for a bank, high-end clients utilized securities-based loans (SBLs), a financial tool which allows them to borrow significant sums using their investment portfolio as collateral.

Intrigued? Well, you can too, but let’s examine the mechanics and why this strategy might not be for everyone.

The Loan Lowdown:

Imagine a treasure chest overflowing with stocks, bonds, and other investments. With an SBL, you can leverage this chest's value to secure a loan. The lender, typically a bank or brokerage firm, assesses the worth of your portfolio and offers a loan amount, usually up to 50% (sometimes even 70%) of the total value. You receive cash, but the lender holds your securities until you repay the loan with interest.

The Balancing Act: Margin Calls and Haircuts

Here's where things get interesting. Or dicey. Unlike traditional loans, SBLs are subject to margin calls. If the market value of your portfolio dips below a certain threshold (determined by the lender, often around 80% of the original value), you'll receive a margin call. This fancy term means you need to deposit additional cash or sell some of your securities to bring the loan-to-value ratio back within the acceptable range.

Think of it like a haircut – the lender wants a buffer to ensure they get their money back. A margin call forces your hand, potentially requiring you to sell assets at an inopportune time.

And who wants to sell when the market is down? (Hint: not me!)

The Benefits of Borrowing Big:

So, why would anyone subject themselves to margin calls and potential asset sales? Here are some reasons SBLs appeal to the wealthy:

• Access to Cash Without Selling: SBLs offer immediate liquidity without disrupting your long-term investment strategy. Need cash for a down payment on a dream property? An SBL allows you to tap into your portfolio's value without selling your prized assets that might be poised for future growth.

• Leveraging Gains: Imagine your portfolio is booming. An SBL allows you to borrow against those gains and potentially amplify your returns by investing the borrowed funds. This can be a risky strategy, but in the hands of experienced investors, it can be a powerful tool for wealth creation.

• Lower Interest Rates: Compared to traditional loans, SBLs typically come with lower interest rates. Since your investment portfolio serves as collateral, lenders view this as a less risky proposition.

The Not-So-Glittering Side:

Don’t start thinking about all the wonderful things you can do with those funds that are tied to your portfolio. While SBLs offer unique advantages, they come with significant risks:

• Market Volatility: Remember margin calls? A sudden market downturn can trigger them, forcing you to sell assets at a loss to meet your loan obligations. (revisit selling at a loss - eek!)

• Debt Burden: SBLs add debt to your financial picture. If your investments underperform, you could find yourself struggling to repay the loan, potentially leading to asset liquidation. And paying taxes on those sales (if sold at a gain).

• Tax Implications: Interest paid on SBLs used for non-investment purposes may not be tax-deductible. Consult a tax professional to understand the specific tax implications for your situation.

Who Should Consider SBLs?

SBLs are complex financial instruments best suited for sophisticated investors with a high-risk tolerance and a well-diversified portfolio. They can be a powerful tool for those who understand the intricacies of the market and have a clear strategy for utilizing borrowed funds.

Disclaimer: I’m a client of Wealthfront, a robo-investing firm and they offer me an SBL on a continual basis as they are the firm that holds my securities. They offer an amount and interest rate based on the size of my portfolio and current interest rates.

So right now I could borrow $21,000 at an annual rate of 8.9%. It’s a nice feature, but it’s still a loan. And if the market starts to fall rapidly, I might have to pony up more $ than my original amount.

SBLs are a glimpse into the world of high-finance. While they offer unique benefits, the risks involved are substantial. Before diving into this realm, carefully consider your financial situation, investment goals, and risk tolerance. Remember, responsible investing is key, regardless of your wealth level.

And if you’re not sure, stick with a lemonade stand for raising cash.

Save On,

Chris