Four Interesting Ways to Borrow Against Your Assets

A few years ago, there was a big story making headlines about how Elon Musk paid zero federal income taxes as one of the wealthiest men in the world at that time. Since then, he has become the wealthiest man in the world, and paid the largest ever single tax bill. Nevertheless, when multiple clients ask “How did Elon Musk not pay any taxes?” back in 2021, it was a great question to ask. The answer is he avoided tax by being smart with debt! Why sell your quickly appreciating Tesla stock for cash when you can borrow against it instead?

When we hear the word “debt,” negative images immediately come to mind. Things like consumer loans and credit card debt are some of the many ways people can get themselves in trouble with debt (bad debt that is). But there can be good debt. In many cases, debt can be leveraged to one’s personal gain when done correctly. This is especially true when borrowing against one’s own assets, like Mr. Musk.

The key times one may want to borrow, or need to borrow are:

• Emergencies: Sometimes life throws a curveball with unexpected expenses like medical bills or car or home repairs, the options below can be quick and less costly ways to access funds when compared to a consumer loan or credit card debt. They can also have faster turnaround times.
• Debt Consolidation: The interest rates on the options below may be lower than other debt, therefore it may be wise to borrow rather than stick with the current payment plan.
• Tax Management: If an asset has large unrealized gains, it may make sense to borrow against it instead of selling it and paying taxes on the gains. If an asset is still appreciating it may make sense to borrow against the asset rather than sell it.

Here are some interesting ways to borrow against one’s own assets:

1. Home Equity Line of Credit

What is it? A Home Equity Line of Credit (commonly referred to as a HELOC) is a line of credit that is taken out against the equity of a home.

• Example: Martha buys a $250,000 home in 2010 with a $200,000 mortgage. In 2023, the home is now worth $425,000 and $100,000 of debt remains on the original mortgage. Her total home equity in 2023 in this situation is $325,000. This home equity is what Martha can take out a HELOC on.

This preapproved line of credit functions like a credit card by providing a line of credit that is available to take out anytime over a specified “draw period” (usually five to 10 years). Once the draw period ends, the remaining balance must be paid back, with interest, over the repayment period (typically 10-20 years). The interest rate on a HELOC is typically variable or floating-rate, so the borrowing costs could rise especially in an environment where interest rates are increasing; this is important to keep in mind as it can impact the benefit of borrowing.

When would be best to consider a HELOC? For those interested in renovating their home or even making minor improvements, a HELOC can provide one of the most logical options for doing so. This is because the IRS allows some interest to be deducted on HELOCs if the funds are used on improving the home.

2. Margin Loan

What is it? Similar to how a HELOC functions, a margin loan can be taken out against assets in one’s brokerage account, ranging from stocks, bonds, mutual funds, ETFs, and other investments. The amount one can borrow, usually 30-50% of the security’s value, will depend on the investments one uses for the margin loan. The interest rates on margin loans also tend to be lower than the rates of credit cards and other consumer loans. However, it is important to be cautious. If the value of the investments one is using as collateral decreases, then one could incur a margin call, which is a requirement to deposit more cash to the account or sell securities to raise cash. It is always best to have a plan of action before taking out a margin loan.

When would be best to consider a margin loan? Many times, day traders use a margin loan to purchase more securities than they could with their cash on hand, which could increase their returns. However, if their investment declines, they can incur a margin call and potentially lose more than their initial investment. Margin can also be useful to raise liquidity when an asset is highly appreciated or appreciating and the debt service cost is below the rate of appreciation.

3.  Securities-based line of credit

What is it? In a way, a securities-based line of credit is similar to a margin loan in the sense that one is borrowing against investments/assets in their portfolio. After the application is approved, one ‘pledges’ the assets used as collateral and they are moved to a separate account. In a margin loan, the assets remain in that brokerage account. One of the main differences is that a securities-based line of credit is made with the bank, not the brokerage firm. There are also more restrictions on what one can use the line of credit for compared to a margin loan. It cannot be used to purchase more investments/securities or repay a margin or other security loan. A securities-based line of credit also tends to have a higher minimum borrowing amount. A plus is the variable interest rate is usually lower than a margin loan’s rate.

Like margin, if the collateral that is pledged decreases in value, the bank will likely demand additional money be deposited or pay the borrowed money immediately. Like the previous options, this is why it is important to understand the risk of taking out a securities-based line of credit before doing so. Diversifying the assets pledged can be a wise decision, and having a solid back-up plan in case the pledged collateral declines in value are all measures of risk management one should take before taking out a securities-based line of credit.

When would be best to consider a securities-based line of credit? A frequent and beneficial situation that utilizes a securities-based line of credit is when a person has put their home on the market but needs or wants to buy their new home as soon as possible. A securities-based line of credit can be taken out on investments and used as a down payment on their new home. When their old home eventually sells, they can pay off the securities-based line of credit with the proceeds from the sale.

One of the best things about a margin or securities-based loan is that interest expense can be considered investment interest for tax purposes and offset investment income.  If the loan is used to buy an investment property or other securities, the interest expense can offset interest income if one’s deductions are itemized on the tax return.

4. 401(k) Loan

What is it? The ability to borrow up to the lesser amount of $50,000 or 50% of one’s retirement account assets. A 401(k) loan is then repaid by rules set forth by the retirement plan, usually through paycheck deductions of after-tax dollars. There is flexibility with the length of the loan, as the borrower can repay the loan over one to five years (with some exceptions if the loan is being used to purchase a house). In addition to flexible repayment, the interest rate is typically lower than most consumer loans, which makes it an interesting option to consolidate high interest debt like credit cards. Another attractive aspect of a 401(k) loan is the loan and interest repayments are paid back to the retirement account, so one pays themselves back rather than a financial institution. The only fee associated with taking a loan is the administrative fee charged by the retirement plan custodian.

There are some drawbacks to taking a 401(k) loan. If the job is lost or left for another, the loan must be repaid in full. If not, then the unpaid balance will be considered a taxable distribution and could incur a 10% penalty if the borrower is under 59 ½. An additional and possible drawback is losing out on market gains while the loan is repaid. This depends on current market conditions, but if the investments increase in value during the loan repayment, then one will have missed out on those gains by taking money from the retirement plan. Conversely, this could work out in one’s favor if the investments lose value during the repayment process.

When would be best to consider a 401(k) loan? Similar to other borrowing, 401(k) loans are best for debt consolidation and emergency cash needs.