How To Use a Securities-Based Loan to Manage Cash Flow

Earlier this year, ProPublica did an exposé of how the ultra-rich pay relatively little income tax. One of the ultra-rich’s techniques is that they live on borrowed money. They don’t sell their appreciated investments and realize capital gains. No realized gains, no taxes. Meanwhile, their investments 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. 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 get a securities-based loan.

What Is a Securities-Based Loan?

When you get a securities-based loan, you borrow money using your securities (stocks, bonds, mutual funds, ETFs, …) as the collateral. It’s not that different in principle 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 a Securities-Based Loan?

People take pride in having no debt but using borrowed money can be better than using your own money in many scenarios. Here are some examples:

Make Illiquid Investment with Confidence

You have some cash and you’re ready to make an investment but this investment requires a 12-month lockup. There’s absolutely positively no way to sell 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 invest with your cash. If nothing comes up in the first 12 months, your investment is liquid now. In case you need the money, you tap the credit line until the lockup is over. You sell the investment to repay 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 bank 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 make a cash offer to buy the new home at your leisure. You move, sell your old home, and repay the loan. It’s worth paying some interest 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 a Securities-Based Loan?

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 loan 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, E*Trade, and Merrill Edge do it through their affiliated bank entity — respectively, Charles Schwab Bank, Morgan Stanley Private 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.
• E*Trade calls it 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. In that sense, a loan from Fidelity or Interactive Brokers is more flexible than a loan from Charles Schwab, E*Trade, or Merrill Edge. 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.

Interest Rate

A securities-based loan 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 a 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, 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 their business by 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 Risks

The biggest risk in a securities-based loan is that you borrowed too much and a market crash triggers forced selling at the bottom.

For example, the broker may require that 70% of your account value 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 after a large drop in 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, the interest is NOT deductible. 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 through Fidelity or Interactive Brokers, the debit balance just compounds within your account. In either case, you can pay down the loan at any time.

Short Box Spread

If you can’t get a good rate from your broker and you don’t want to move to Interactive Brokers, you can also borrow against your taxable investments by selling short box spreads.

You’re effectively borrowing from the market participants. The market sets the rate, not your broker. It works at any broker and you don’t have to move your account. See Short Box Spread Trade vs Margin Loan.

***

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.