inVeSTing
est expense when the line is used . Since the credits are secured by liquid collateral , the interest rates are typically attractive , especially if the borrower is using the line only for true short-term cash obligations . Most lines of credit have floating interest rates based on an index , such as the prime rate or secured overnight financing rate , with an appropriate spread attached .
Securities-Based Lines Of Credit Versus Asset Sales
There are many reasons to have a securities-based line of credit available . One reason is that your client can avoid otherwise selling an asset quickly or unnecessarily ( and paying the corresponding taxes ) just to get fast access to cash . The timing of such a sale can affect the client ’ s wealth plan , given the potential long-term capital gain taxes and recognition of unnecessary losses . Also , there ’ s the opportunity cost : By liquidating assets in the stock market , your client might miss out on greater returns .
The tables below compare the two choices at hand .
scenario 1
Asset Sale take a $ 5 million portfolio . Here , a client liquidates $ 1 million and pays a long-term capital gains tax of $ 200,000 , leaving $ 800,000 in proceeds . with a return on the remaining assets of 6 %, the client ’ s portfolio gains $ 240,000 , resulting in a value of $ 4,240,000 .
securities Portfolio . . . . . . . . . . . $ 5,000,000 securities sale ................$ 1,000,000 lng-trm cap gain tax ( 20 %).. ($ 200,000 ) resulting Proceeds .............$ 800,000 remaining Portfolio assets ... $ 4,000,000 Portfolio return ( 6 %) .......... $ 240,000 interest on line of credit . . . . . . . . . . . . . . $ 0 net gain ......................$ 240,000 ending Portfolio Value .......$ 4,240,000
Examples shown are for illustrative purposes only and do not represent an actual portfolio . They should not be construed as indicative of future loan terms or a guarantee of any level of performance .
Securities-Based Credit Versus Mortgage-Based Financing
An alternative to a securities-based line of credit is a home equity line of credit or a cash-out mortgage refinancing . There are pros and cons to these financing options . One benefit of residential mortgage-based lending is that the credit commitment is typically longer , there is a long-term fixed interest rate , and some of the client ’ s interest expense is tax-deductible . On the other hand , the time from application to approval is longer than it would be in a securities-based facility . Furthermore , residential lending solutions require a significant amount of documentation — such as tax returns , bank statements and paychecks — and the bank will perform an appraisal on the home . Alternatively , the largest benefit of a securities-based line of credit is the ease of qualifying and establishing the facility .
Market Volatility : Managing The Risk
Securities-based lines do come with some risk . If the advance rate is too high and the value of the collateral declines
Borrowing Scenarios : An Asset Sale Versus A Line Of Credit
scenario 2
Line Of Credit
Here , with the same $ 5 million portfolio , the client takes out a line of credit instead , leaving the portfolio fully invested . the client achieves the same 6 % return , producing a gain of $ 300,000 and a net benefit of $ 260,000 ( after taking the first-year interest expense on the line of credit into account ). the portfolio ends up being worth $ 5,260,000 .
securities Portfolio . . . . . . . . . . . $ 5,000,000 securities sale ........................ $ 0 lng-trm cap gain tax ( 20 %) .......... $ 0 resulting Proceeds .................... $ 0 remaining Portfolio assets ... $ 5,000,000 Portfolio return ( 6 %) .......... $ 300,000 interest on line of credit . . . . . . .($ 40,000 ) net gain ......................$ 260,000 ending Portfolio Value .......$ 5,260,000 substantially , the portfolio might have to be liquidated to pay off the outstanding balances . It is important to know the trigger points , or default rates , when this will occur , and to understand the bank ’ s procedure for notifying clients if the advance rate becomes an issue . If a credit line does exceed the default rate and the lender sells assets to pay down the outstanding credit , this can spur the same tax consequences the client was trying to avoid . So it ’ s important for the client to closely monitor the line of credit against the value of the portfolio , especially when markets are volatile or suffering sustained downturns .
Clients should look for lenders who will be proactive , communicating with them early on if there are margin problems , which is especially important during periods of market turmoil . It ’ s critical for the client and wealth team to work together ( and talk regularly ) to explore alternatives to liquidation . For instance , a client could add unencumbered liquid assets to the collateral , use excess cash to pay down the lines , or liquidate only those assets that will trigger minimal taxes . While automatic liquidation of assets is an option on these lines of credit , a lender may be able to work with the client to avoid it . But even with or without constant communication , the clients must know that it ’ s 100 % their responsibility that the credit remain within margin .
Part Of Your Plan
In any case , a securities-based line of credit should be an integral part of a client ’ s wealth management plan . Whether or not a client needs financing , such credit lines offer them more financial flexibility at a lower cost . Moreover , these facilities let clients leave their assets in the market to potentially capture additional returns and avoid tax consequences — thus affording them the opportunity to maintain or further build wealth .
DAn SuLLiVAn is a managing director and head of private banking and mortgage for ciBc Private wealth , u . s ., with more than 25 years of industry experience . in this role , he is responsible for developing client relationships to deliver ciBc ’ s broad array of wealth solutions to clients .
56 | financial advisor magazine | july / august 2022 www . fa-mag . com