Earlier this year, ProPublica did an exposé of how the ultra-rich pay relatively little income tax. One of their techniques is that they live on borrowed money. They don’t realize capital gains when they don’t sell their appreciated assets. No realized gains, no taxes. Meanwhile, their assets keep growing, and banks are increasingly comfortable lending them more money for their spending. Wall Street Journal called this strategy “Buy, Borrow, Die” (audio starts at 7:27).
We the small-time investors can do it too through the same mechanism. We can’t live on borrowed money for the rest of our lives but we can use borrowed money for a short while when we use securities-based lending.
What Is Securities-Based Lending?
When you use securities-based lending you borrow money using your securities (stocks, bonds, mutual funds, ETFs, …) as the collateral. In principle, it’s not that different than getting a HELOC using your home as the collateral.
Because your investments are much more liquid and easier to value than your home, you can get the loan much faster and at a lower interest rate than from a HELOC. You don’t need to prove your income. The interest rate can be 2% below the Prime Rate, whereas the rate on a HELOC is usually close to the Prime Rate.
When Do You Need Securities-Based Lending?
People pride themselves on having no debt, but using borrowed money can be better than using your own money in many scenarios. Here are a few examples:
Make Illiquid Investment with Confidence
You have some cash and you’re ready to buy I Bonds for the great interest rate, but you’re concerned about the 12-month lockup. There’s absolutely positively no way to sell I Bonds in the first 12 months, not even when you’re willing to pay a penalty. What if you need the money during that time? Selling other investments triggers capital gains, throws you over income limits, and disqualifies you for this or that.
When you have a standby credit line available, you can go ahead and buy I Bonds with your cash. If nothing comes up in the first 12 months, your I Bonds are liquid now. In case you need the money, you tap the credit line until the lockup is over. You sell I Bonds to repay the loan. Your I Bonds will earn much more interest than the interest you pay on the loan.
Stop Parking Cash
People ask quite often “Where can I park a sum of cash for a year or two?” The answer is usually a money market fund, a savings account, a Treasury Bill, or a CD because the timeframe is too short.
When you have a standby credit line available, you can keep the money in your diversified portfolio. Chances are you will earn more than the short-term interest rate in your portfolio by the time you need the money, but if it has a loss, you can tap the credit line. You pay off the loan when your portfolio recovers.
Bridge a Gap
You’re buying a home. Making your purchase offer contingent on selling your current home will make it unattractive to the seller in a competitive market. Selling your current home first and getting a rent-back makes you overbid to buy before the rent-back runs out. Renting after you sell means you have to move twice.
When you have a standby credit line available, you can tap it to buy the new home at your leisure. You move, sell your old home, and repay the loan. It’s worth paying some interest at a low rate to make it all smooth.
Lower Your Taxes
You want to sell some investments to help your daughter buy a home. Selling them all this year will trigger large capital gains but if you split the gains across two calendar years, each half of the gains will fall in the 0% tax bracket.
So you sell half and borrow half. Your daughter gets the home now. You sell the other half next January and repay the loan. The tax savings are much higher than the interest you pay.
Where Do You Get Securities-Based Lending?
You get it from the broker that holds your investments. If your current broker doesn’t offer it at an attractive interest rate, you have to be willing to move your account to one that does. Some banks also offer this type of lending through their private banking departments.
You can only borrow against your regular taxable brokerage account. IRAs and other tax-advantaged accounts can’t be pledged for loans but the broker may consider them in the overall relationship when they determine your interest rate.
Charles Schwab, TD Ameritrade (owned by Charles Schwab now), E*Trade, and Merrill Edge do it through their affiliated bank entity — respectively, Charles Schwab Bank, TD Bank, E*Trade Bank, and Bank of America. Officially the affiliated bank is making the loan against your taxable brokerage account held at the broker. They all have different names for their programs:
- Charles Schwab calls it Pledged Asset Line.
- TD Ameritrade calls it Collateral Lending Program.
- E*Trade calls it E*Trade Line of Credit.
- Merrill Edge calls it Loan Management Account.
Fidelity and Interactive Brokers lend directly as a margin loan.
The difference between a line of credit through an affiliated bank and a margin loan through a broker is that the bank loan can’t be used to purchase securities, pay down margin loans, or be deposited into a brokerage account, while the margin loan doesn’t have such restrictions. However, there’s no practical difference when you use the loan only for cash flow needs because you aren’t using it for those restricted purposes anyway.
The differences among the brokers come down to the interest rate and how much they let you borrow.
Securities-based lending typically uses a variable rate tied to a short-term market rate plus a fixed markup. There’s usually no setup fee or maintenance fee to keep the credit line open and unused.
Interactive Brokers is known for their low margin rates. They post their rates transparently online. The rate is a blended rate based on how much you borrow. At the time I’m writing this, the rate under the IBKR Pro pricing plan starts at around SOFR + 1.5% on the first $100k and it goes down to around SOFR + 1% on the next $900k.
A fintech startup M1 Finance offers margin rate starting at around SOFR + 2% in their M1 Plus program ($125 annual fee).
The officially posted interest rates at other brokers — Fidelity, Charles Schwab, TD Ameritrade, E*Trade, and Merrill Edge — are all much higher. However, if you have large accounts at one of these brokers, they’re often willing to offer you a special rate close to the margin rate at Interactive Brokers to keep your business.
You should contact the rep assigned to your accounts or someone at their physical branch. Don’t just call their 800 number. The reps at the call center may not be familiar with or authorized to offer special rates. I have read multiple reports of people getting offered a rate lower than SOFR + 1.5% at these brokers. Here’s one report from the Bogleheads investment forum for example:
As one data point one of our adult kids just got PAL [Pledged Asset Line] at Schwab for a $250k draw supported by $500k brokerage account there with rate of 1.40 plus SOFR.
For comparison, the online calculator at Interactive Brokers shows their blended rate for borrowing $250k is SOFR + 1.23%. Charles Schwab’s rate at SOFR + 1.4% isn’t too far off.
Vanguard also offers margin loans but I haven’t heard of anyone getting a similarly low rate from Vanguard.
If you can get a special rate at your current broker close to the rate offered by Interactive Brokers, you probably should stay. If you’re with Vanguard and you’re willing to move, you can shop among those other brokers and see who offers you the lowest rate.
Interactive Brokers is quite different than other brokers. Because they started from serving institutional customers, even though they also serve retail customers now, they expect you to know what you’re doing. Many things you take for granted at other brokers are either not available or difficult to figure out. It isn’t for the faint of heart. Use Interactive Brokers only when you want a low rate and you can’t get it anywhere else.
How Much Can You Borrow?
Each broker sets the rules. The amount you can borrow is only determined by the value of the investments in your account. There’s no debt-to-income requirement. It can be 50% or 70% of the value of your taxable account, but you probably shouldn’t borrow nearly as much anyway.
The biggest risk in securities-based lending is that you borrowed too much and a market crash will trigger forced selling at the bottom.
For example, the broker may require that 70% of your account value must be greater than your outstanding loan at all times. Suppose you had $100,000 in your account and you borrowed $50,000, and after the market drops, your investments are worth only $70,000 now. 70% of $70,000 is $49,000, which is lower than your $50,000 loan outstanding. Now the broker can sell a part of your investments to pay down the loan, precisely when you don’t want to sell at the bottom of the market. The forced sale may trigger capital gains tax as well.
To guard against a 50% drop in the value of your investments, you probably shouldn’t borrow more than 30% of the account value. It helps if you have a balanced portfolio in your brokerage account that isn’t prone to a 50% drop to begin with. It also helps if you don’t carry the loan for a long period of time.
How Do You Draw From the Credit Line?
You may not be able to borrow right away after you sign up for the feature. Set up the account ahead of time and wait until you’re eligible.
Once the credit line is ready to use, you simply make a withdrawal to a linked bank account as needed. Or you can request a wire transfer. You pay interest only on the amount outstanding.
Is the Interest Deductible?
In general, no. Interest on personal loans isn’t tax-deductible. Even if you use the loan to buy a home, the interest is still not tax-deductible when the home isn’t used as collateral for the loan.
If you have a margin loan and you use it to buy additional securities, which isn’t what we’re talking about here, the interest is deductible up to your net investment income but only if you itemize deductions. Because most people don’t itemize, the interest ends up not getting deducted anyway.
Do You Need to Make Payments?
You may need to make monthly interest-only payments when you have the loan through a bank affiliated with the broker. When you have a margin loan, the debit balance just compounds within your account. In either case, you can pay down the loan at any time.
Excessive borrowing is risky but borrowing prudently at a low rate can make many things a lot easier. If you have a large taxable account, learn from the ultra-rich and put it to good use. You end up saving money in many cases.
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I love this, thanks so much.
With so much at Vanguard, I was hoping they were going to be a better player here.
Eric B says
Just to emphasize what Harry said: Interactive Brokers’ interface is extremely convoluted and confusing. Find some way to give it a test run before you commit to it!
I moved my ETFs to IB recently precisely for their low margin loan rates and I’m really regretting the move. If I got incapacitated tomorrow, there is no way my family or friends could possibly handle IB’s interface — you have to download and install a huge Java application just to manage tax lots! They also spam my email with useless “FYI” emails and now they’re pushing crypto.
Many people are very happy with IB, and they do have the best margin rates, but I am already making plans to go elsewhere, for sanity’s sake. I’m currently deciding between moving my ETFs to Fidelity and hoping they’ll lower my margin rate or moving a chunk to M1+ (2% rate), and keeping the rest at Vanguard (because their interface is actually simple).
Eric. how are you…great share. Looking around within IB, I was thinking the same. Currently at Fidelity but just recently heard about this “leverage” option via LMA at ML. I like the LMA option but does seem pricy and it seems Fidelity is comparable in price to borrow against your own portfolio. With ML wanted to leverage endeavors outside of trading (having just learned about this). What have you decided to do?
My security assets and banking are with Fidelity. Their margin rates are higher than I expected, especially when compared to IB. I’d like to approach Fidelity about establishing a 1.0 – 1.5 rate similar to IB, however, I have no immediate plans to take out a margin loan against my holdings. Will Fidelity match IB’s rate or structure and hold that rate for future loans going out a couple of years? I’d like to set it up now so I have it ready when needed. Please comment. Thanks.
Harry Sit says
Brokers are motivated by your borrowing and paying interest. If you really have no need to borrow in the next couple of years, wait until six months to a year before you plan to borrow. That’s still enough time to set it up and you have the strongest leverage at that time.
There may be considerations beyond lower interest rates. Mortgages typically are non-recourse in many states. Given the elevated home prices, if there is a home price deflation event like 2008, then having a mortgage may be better than security lending. You will have to consider your total financial picture.
Harry Sit says
I’m not suggesting securities-based lending should be used in lieu of a mortgage or to pay off a mortgage. In the “buying a home” example, it’s used only to bridge the short gap between buying and selling. In the “helping daughter” example, it’s used only to help the daughter with the down payment.
Thanks, Harry! I know it wasn’t the point of the Pro Public report, but I also found myself thinking… why can’t I do it too?
Frugal Professor says
Great article. I’ve been considering this for some time and it was helpful to see it all written out. Thank you!
Thanks Harry for putting this out there. Great article
another frugal professor says
Let’s say I have money at M1 or IB that I could borrow from and it would be less than my mortgage rate. And, let’s say I normally pay an extra amount on each mortgage payment to pay it off a little early. If I understand the article right, I could use the M1 or IB account and borrow 6 months or a 1 year’s worth of the extra amounts I pay towards my mortgage, and pay down my mortgage with it. Borrowing only 6-12 months would keep the amount borrowed so low relative to the amount invested that I would never get a margin call unless the market went down by 90 percent. And borrowing only 6-12 months would minimize exposure to the possibility of rising interest rates. Does this check out or make sense, I feel like I might be missing something in my desire to use this information and save a little extra.
Harry Sit says
The two risks are liquidation from borrowing too much and variable rate rising. You have them covered. After you pay down the mortgage with a margin loan, what will you do with the cash you’re currently paying extra toward your mortgage?
– Spend it. You’re doing a mini-refi. Your rate is a little lower (and it changes from fixed to variable) but your total loan balance isn’t going down.
– Invest it. You’re borrowing to invest, which you can do now by stopping the extra payments.
– Pay down the margin loan. Your total loan balance goes down a little faster due to the lower rate and you lower the risk of the variable rate rising.
On Bogleheads, there is a discussion of using box spreads to accomplish a similar thing, including example screen shots from Fidelity, Ameritrade, and IB. It is slightly more time consuming to construct but is worth looking at. The advantage here is that there is no “interest” paid, the cost of borrowing is embedded in the amount received. You mark to market what the box is worth on Form 6781 every year, which should be a slight capital loss if rates stay the same.
I appreciate articles on this topic.
I continue to find it confusing that a strong justification is, as the top of the article states, “The current interest rate can be a little over 1%”,
however, the rest of the article shows that 1% is very hard to find and most rates are much higher and/or there are misc fees to contend with. So implementation seems difficult, especially if one does not have a large traditional account. More specifics could be useful, but understandably hard to provide.
Harry Sit says
Admittedly the rate can be a little over 1% at mainstream brokers only for those with large accounts. If you do have large accounts, you only have to ask the rep assigned to your accounts or someone at their local branch.
I find this alternative (from another article you referenced) very interesting
Great article. If you use a securities backed loan to help purchase an investment rental property, is the interest tax deductible in that case? It seems like it should be, because the proceeds are used for 100% investment purposes.
I’m not an expert, but my understanding is the loan “cost” would show as a securities loss, which can be used to offset securities gains or against $3k regular income. I think how the “Loan” is used is irrelevent.