Personal Business: SMART MONEY
BORROWING ON MARGIN SURE LOOKS TEMPTING
With all the wealth accumulated during the prolonged bull market, margin borrowing takes on new appeal. It's a great leveraging strategy if you need quick access to cash at rates considerably lower than those on personal loans at banks. But there are obvious dangers inherent in borrowing money based on the expected performance of your portfolio.
A margin account is simply a secured loan used to buy additional securities or cover personal expenses. Brokerages will extend credit of up to 50% of the value of your stocks, mutual funds, or convertible bonds. On less-volatile government bonds, you may borrow up to 95% of the value.
DANGER AHEAD. At 8.25% to 8.75%, margin-loan rates are relatively low, compared with the 15% charged by many banks for unsecured personal loans. The minimum interest rate allowed on a margin loan is half a point above the "broker loan rate," or what banks charge brokerages to borrow money. The rate now is 7.25%, but check your newspaper frequently for changes. If the loan is used for investment purposes, you may deduct only interest that would offset your investment income. There is no deduction, however, if you borrow to buy tax-exempt securities. Consider a home-equity loan first, since the interest on up to $100,000 borrowed is fully tax-deductible. The average rate is 8.86%.
Using a margin loan means shouldering some risk. If your investments take a dive--as happened lately with tech stocks--and the equity in your account falls below 30% of its current market value, your broker will issue a margin call to pay off some of the loan. If you can't come up with the cash or additional securities to satisfy the call, your broker will liquidate assets in your portfolio--possibly at a loss.
Still, margin loans can be a low-cost way to finance short-term needs, says Gregory Sullivan, president of financial planning firm Sullivan, Bruyette, Speros & Blayney in McLean, Va. Short-term uses include college tuition payments or sudden medical costs. One of Sullivan's clients, for example, knew he would get a bonus in three months. In the meantime, he needed to pay his child's $20,000 college tuition. "Instead of disturbing his $200,000 portfolio, we took a margin loan on 10% of his account and paid it off when he got the bonus," says Sullivan.
Only investors with the resources to absorb serious losses should borrow on margin. "Anyone who has a small amount of assets or has to fully leverage themselves shouldn't use a margin loan because they have nothing to fall back on," says Richard Gemberling, senior vice-president at Smith Barney in New York. And margin loans should never be used to finance existing debt: The slightest drop in the market will push you deeper into the hole, cautions financial adviser Nancy Dunnan, author of Dun & Bradstreet Guide To Your Investments 1996 ($18.95, HarperCollins).
There are some things you can do to minimize the risks inherent in margin loans. The first rule is to deal with a broker you know and trust. "You need someone who knows your whole financial picture and advises you accordingly," Dunnan says. When you're using a margin loan to buy additional securities, keep in mind that brokers may have an incentive to encourage trading to generate commissions.
Second, borrow less than the maximum allowed. The bigger the loan, the more likely it is that slight market fluctuations will trigger a margin call (table). Your broker should inform you if the account is approaching the margin call level but Dunnan advises monitoring the prices of margined stock yourself to avoid surprises.
LESS RISK. Borrowing against more stable assets also reduces the chance of a margin call. A diversified mutual fund is likely to be less volatile than an individual stock. "You get the same benefits of leverage as borrowing against common stock but with less downside risk," says Tom Taggart, a spokesman for Charles Schwab & Co. For more information, write to the New York Stock Exchange, Communications Dept., 11 Wall St., 12th floor, New York, N.Y. 10005, for a free copy of The Margin Trading Guide.
If you choose to borrow against your newfound stock riches, bear in mind that the 37.5% average returns of the Standard & Poor's 500-stock index in 1995 were an aberration. Historically, the stock market has returned 10% to 12% a year. So Sullivan cautions his clients not to finance short-term needs based on unrealistic projections of market performance.
"Managing what you owe is as important as managing what you own," says Hal Minot, director of marketing at Merrill Lynch Credit in Jacksonville, Fla. It is especially crucial when what you owe is linked to an asset that has the capability to plunge in value overnight.By Kerry CapellReturn to top