Back in June I wrote about how to decide if you should be saving, investing, or paying (down debt). This post is to supplement that post: if you’re paying down debt, that doesn’t mean you can’t invest until you’re debt free. You can do both via the margin feature on your regular brokerage account. Note: this step is still secondary and maintaining emergency savings buffer of 3-6 months of spending should still be the first step.
Margin is a type of loan given by the brokerage firm where your investments are held. The loan uses your investments as collateral. This means the greater the value of your investment account, the more you can take on margin. Margin allows debtors to decrease their net debt interest rate by acting as a self directed debt consolidation strategy. The idea is that you withdraw money from your brokerage account by means of a margin loan at a lower interest rate, and use the cash to pay down debts with higher interest.
Debt interest is a negative performing asset on your balance sheet and the higher the rate of interest, the worse it is. Here’s an article explaining the impacts of high interest debt on your financial future – TLDR: it’s bad.
Below are three benefits to using margin to pay down debt:
- You can invest and pay down debts at the same time.
- Often times, the margin interest will be lower than a traditional debt consolidation loan. According to Bankrate.com, the average loan interest rate as of November 2020 was anywhere from 5.99% to 35.99%. Interactive Brokers (brokerage firm) is currently offering margin interest starting at 2.58%, decreasing by tiers as you increase the asset value of your brokerage account.
- Flexibility. You can pay down the margin loan at your own pace as long as you don’t get a margin call (see below). In the event of an emergency, your cash flow won’t be affected by mandatory payments on your margin loan. This is is true as long as you don’t sell your investments and emphasizes the importance of having a savings bucket first.
And here are the three potential dangers from this strategy:
- Investments can be volatile. Market values of the global markets fluctuate daily. Volatility is dangerous because of a margin call. Because the margin loan uses the investments as collateral, if the value of the investments drops too much, then you would have to pay down the margin loan until the value of the assets and the loan is back to its agreed upon ratio. An investor using this strategy should invest in more stable investments, like bonds. If you’re utilizing this strategy, it’s also a good idea to have some buffer in the ratio of loan to assets so that you’re less susceptible to daily volatility and can afford some slack.
- Bonds present a high opportunity cost because they are low risk investments. Stocks and other riskier investments are expected to generate greater returns over the long term. However, the chance stock investments result in a margin call is also higher. While the opportunity for potential positive returns is less, the opportunity to reduce debt interest is guaranteed because you know the difference in your high interest debt and the margin loan rate. For example, paying down a credit card with an interest rate of 18% using a 2% margin loan is essentially an investment gain of 16%.
- Just like any investment, margin debt has interest. Essentially, you’re moving one type of debt (high interest) to another kind (low interest). Interest is the cost of borrowing money and will be a driver of negative value to your net worth. The longer margin debt stays on your balance sheet, the more in interest it’ll cost you. Ideally this interest would pay for itself from the expected return from the investment account used as collateral, but this isn’t always the case. Nonetheless while you have higher interest debt, it’s still a positive impact on your balance sheet to pay that down using low interest margin debt.
Paying down debt can be daunting. Using margin can make it easier while also allowing the debtor to invest toward their future. If you’re considering using this strategy, I would recommend speaking with a professional due to its riskier nature.
Just remember, I’m not your financial advisor so the information may or may not best apply to your situation and you should get formal advice prior to doing anything. The information/data that is shared should be double checked by you and any conclusion that is driven based on past data is not to be interpreted as my advice for your future. I will do my best to only write what I think is true and right, but mistakes happen and we’re all learning together – this is meant to be a conversation. My employer has nothing to do with this blog – in fact, they’re probably upset I’m writing here instead of working.