Key Takeaways
Sometimes selling stock or other investable assets to raise cash for major purchases makes sense, but not always.
Debt can be your friend when used responsibly. See below for manageable options.
Before pulling the trigger on a major purchase, ask yourself if it’s a need or a want.
Clients often ask us for advice about financing major purchases such as a new primary home, a second home, a kitchen renovation, a new boat, a car, or even an RV. In many cases, they can raise the cash by selling investable assets. Of course, that triggers capital gains and other tax consequences. Plus, it takes that money out of circulation, so it can no longer grow for retirement.
We’ve been spoiled by “cheap money” for the past 15 years, but now that the Fed has raised interest rates aggressively, suddenly we have to start putting some thought into how we finance major purchases. When determining the best course of action, it’s not just the amount you want to borrow, but how long you need the money, what your projected income is, and what your tax considerations are. Most of our clients are fortunate to have ample assets and resources. Usually, financing a purchase doesn’t make sense for them unless they are able to find a low interest rate line of credit. Something that can occasionally be found when doing home renovation projects.
Short-term “bridge” loans. Sometimes, people want to purchase a new home but haven’t sold their existing home yet. While it’s expensive to carry two homes, if we’re only talking about a few months, you can borrow that money via a home equity line of credit (HELOC) or margin loan from your brokerage account. More on those in a minute. Once the house sells, you can pay back the short-term bridge loan with the proceeds. Again, these are strategies for financing major purchases, but not for discretionary expenses like vacations.
HELOC. Here you borrow against the equity you’ve built up in your home. The more equity you’ve built up, the larger the line you qualify for, especially if your loan-to-value ratio is low (banks will need a recent appraisal). A HELOC provides you with a revolving credit line to use for large expenses, for emergencies, or for consolidating higher-interest rate debt on other loans. A HELOC often has a lower interest rate than other common loans, and the interest may be tax deductible if used for home renovations. You can also pay back the outstanding balance as fast or as slow as you prefer as long as you make the monthly minimum payments. HELOC terms usually have a 10-year borrowing period and then a 20-year payback period. Of course, you can pay back the loan earlier if it makes sense to do so.
A margin loan is a flexible line of credit in which you borrow against the value of securities in a brokerage account instead of borrowing against your house as with a HELOC. You can typically borrow up to 50% of the account value in your brokerage account. Margin loans are simple to set up and there are no up-front fees. Interest, usually paid monthly, may be tax-deductible, and repayment terms are generally quite flexible—as long as you don’t get too close to your 50% margin limit.
Both of these options are considered “collateralized” loans. HELOCs use your house as collateral; margin loans use your investable assets as collateral. Collateralized debt is always better than an unsecured line because you’ve backed the loan with your assets. Since that’s a lower risk for the lender, you’ll get a better interest rate and payback terms—and often lower fees.
HELOC vs. margin loan? Clients sometimes ask if they’re better off with a HELOC or margin loan. HELOC rates are in the 7.5% to 10% range while margin loans are currently over 11%. That may sound high but compare that rate to credit card interest which can be over 20%. So, when it comes to HELOC vs. margin loan, if a client has a decent amount of equity built up in their home then, we generally recommend the HELOC. But, if they have a robust brokerage account and/or recently moved into a new home and have a sizeable mortgage and relatively little home equity so far, then the margin loan is often the better option.
A home equity loan is similar to a HELOC in which your house is used as collateral. Instead of opening a line as you do with a HELOC, however, you simply receive a lump sum from the bank based on the agreed-upon amount and the repayments start immediately. Unlike the HELOC, there are usually closing costs associated with home equity loans and the only advantage to a home equity loan over a HELOC is that usually you can borrow a higher amount. For instance, a borrower who qualified for a $300,000 home equity loan, might only be able to get a $200,000 HELOC. However, the repayment terms aren’t as flexible with a loan as they are with a line of credit.
Borrow from family members. This is often the fastest, simplest, and least costly option. Just make sure you have some documentation around the loan specifying how much was borrowed, when it was borrowed, when it must be paid back, and how much the interest rate is. The documentation can be a simple IOU, a promissory note, or a formal intra-family loan agreement. The point is to show the loan is intended to be paid back. Otherwise, it could be construed as a gift. You should be prepared to charge fair market interest. A good place to start is the IRS Applicable Federal Rate (AFR) which is currently just under 5%.
Wants vs Needs
Before going through the pros and cons of different financing strategies I’ve found it helpful to ask clients if a major purchase they’re considering is a want or a need. Luxury cars, boats, and fine art are usually wants. But buying a larger primary residence because you have children on the way is more of a need. What if that decision affects other financial goals in the future? The same goes for luxury cars and boats. We help clients work through the thought process behind a major purchase and determine how the purchase will affect their other goals. Can they afford it and what’s the best way to make it happen without derailing their financial plan? Conclusion
Again, no two clients have the same situation. If you or someone close to you has concerns about financing major purchases or unexpected expenses, please don’t hesitate to reach out. We’ve helped many clients like you in similar situations.
RYAN A. DUNN, CFP®, is a Wealth Manager at Novi Wealth