The Finance Buff

The Finance Buff - October 17, 2021

Earlier this year, ProPublica exposed how super-rich individuals pay relatively little income tax. One of their tricks is living off borrowed money. When they don’t sell appreciated assets, they don’t realize capital gains. No realized gains, no taxes. Meanwhile, their assets continue to grow, and banks are increasingly willing to lend them more money for their spending. The Wall Street Journal called this strategy 'buy, borrow, die' (audio starts at 7:27).

We small investors can also achieve this through the same mechanism. We cannot live the rest of our lives on borrowed money, but when we use securities-based lending, we can temporarily use borrowed money.

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 lending?

When you use a securities-based loan, you use your securities (stocks, bonds, mutual funds, ETFs, etc.) as collateral to borrow funds. In principle, this is no different from using your home as collateral to obtain a HELOC.

Since your investments are more liquid and easier to value than your home, you can obtain a loan faster and at a lower interest rate compared to a HELOC. You do not need to prove your income. Current rates may be slightly above 1%, whereas HELOC rates are typically close to the prime rate, which is 3.25% today.

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 current interest rate can be a little over 1%, whereas the rate on a HELOC is usually close to the prime rate, which is 3.25% today.

When do you need a loan based on securities?

People take pride in being debt-free, but in many cases, using borrowed money is better than using your own money. Here are some examples:

Confidently engage in illiquid investments

You have some cash and are ready to buy bonds at a high interest rate, but you are concerned about the 12-month lock-in period. There is absolutely no way to sell the bonds within the first 12 months, even if you are willing to pay a penalty. What if you need money during that period? Selling other investments would trigger capital gains, pushing you over income limits and causing you to lose eligibility for this or that.

When you have available backup credit, you can continue to buy bonds with cash. If there is no progress in the first 12 months, your bonds are now liquid. If you need money, you can tap the credit until the lock-up ends. You sell bonds to repay the loan. Your bonds will earn more interest than the interest you pay for the loan.

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 reserving cash

People often ask, 'Where can I put a sum of cash for a year or two?' The answer is usually a savings account or a CD, because the time frame is too short. If you're lucky, both now pay about 1%.

When you have an available credit line, you can keep your funds in your diversified investment portfolio. When you need the money, your portfolio may earn more than 1% in returns, but if losses occur, you can use the credit line. When your portfolio recovers, you 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 savings account or a CD because the timeframe is too short. Both pay about 1% right now if you’re lucky.

When you have a standby credit line available, you can keep the money in your diversified portfolio. Chances are you will earn more than 1% 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 the gap

You are buying a house. In a competitive market, making your purchase offer contingent on selling your current home will make it unattractive to the seller. Selling your current home first and securing a rent-back will mean you are bidding too high before the rent-back period ends. If you sell first and then go out to rent, it means you have to move twice.

When you have available backup credit, you can tap it leisurely to buy a new house. You move, sell your old house, and then repay the loan. It is worth paying some interest at a low rate to make everything go smoothly.

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.

Reduce taxes

You want to sell some investments to help your daughter buy a house. Selling them all this year will trigger a large capital gain, but if you split the gains over two calendar years, each half of the gain will fall within the 0% tax bracket.

So you sell half and borrow half. Your daughter has now returned home. You will sell the other half next January and repay the loan. The tax savings are much higher than the interest you pay.

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 obtain securities-based loans?

You get it from the broker who holds your investments. If your current broker does not offer it at an attractive rate, you must be willing to transfer your account to one that offers favorable rates. Some banks also offer such loans through their private banking departments.

You can only borrow through your regular taxable brokerage account. IRAs and other tax-advantaged accounts cannot be used as loan collateral, but brokers may consider them in your overall relationship when determining your rate.

Charles Schwab, TD Ameritrade (now owned by Charles Schwab), ETrade, and Merrill Edge respectively provide this through their affiliated banking entities—Charles Schwab Bank, TD Bank, ETrade Bank, and Bank of America. The affiliated banks formally extend loans to your taxable brokerage account held with the broker. Their programs each have different names:

Charles Schwab calls it the Pledged Asset Line.

TD Ameritrade calls it the Collateral Lending Program.

ETrade calls it the ETrade Line of Credit.

Merrill Edge calls it a Loan Management Account.

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), ETrade, and Merrill Edge do it through their affiliated bank entity — respectively, Charles Schwab Bank, TD Bank, ETrade 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.

• ETrade calls it ETrade Line of Credit.

• Merrill Edge calls it Loan Management Account.

The Finance Buff: (Source of information)