Appendix B
Understanding the Power of Securities-Based Lending
Securities-based loan (SBL) facilities allow you to borrow against liquid investable assets to finance almost anything except the purchase of additional securities. They offer many advantages and better terms: rates under prime, no amortization, no required monthly payments, no cost to establish or maintain, and limited underwriting. If you have $300,000 of qualifying investable assets, you could put an SBL in place with a maximum loan of $150,000—though you should never draw more than 50 percent of your available line, or $75,000 in this example.
How does this work? Suppose you just got a bonus and need a new car. You have your eye on a $40,000 car. Your first impulse—like most people's—is to get a 4-percent loan with a four-year amortization schedule, resulting in a monthly payment of about $900 per month. Those terms stink.
Instead, you could put the $40,000 on your SBL at a cost of about 4 percent. You would pay about $1,600 a year, or $133 a month, in interest ($40,000 × 4% = $1,600/12 = $133 per month), as opposed to roughly $900 a month.
Is this an apples-to-apples comparison? Not exactly, because the amortized loan includes a principal payment. But you can never underestimate the financial flexibility that a lower monthly payment provides. You can pay down principal whenever you want. The key is that you—not the bank—are in control of the payment schedule. You're not tying up capital in a depreciating asset.
In fact, as long as your line is in good standing, you don't even have to make a payment. You can let the interest capitalize, which is where it is added to the loan. While this might not be a good long-term strategy, it can provide a tremendous amount of flexibility during a tumultuous time, such as a job loss or emergency.
Case Study
The power of a securities-based line of credit starts to come into your life during Phase 3: Equilibrium. Let's look at Brandon and Teresa at the end of this phase. When their after-tax investment portfolio is at $280,000, they would have access to a line of credit for about $140,000. I recommend that they never use more than $70,000 of that line. Often times, these lines have a minimum of $75,000 and therefore require that you have at least $150,000 in liquid, after-tax assets to set one up. So at some point as they follow the beacons and focus on building up assets more than paying down debt, they will gain access to this tool. People who don't ever build up liquid assets lose the potential power of these borrowing strategies and get stuck in inflexible debt.
Table B.1 shows Brandon and Teresa at a hypothetical midpoint of the Freedom phase. They have built up savings and are building up their taxable and tax-deferred retirement savings accounts.
Table B.1 Brandon and Teresa Midpoint of Equilibrium
| Goal/Bucket | Formula | A Balanced Path | Where You Are | Gap |
| No oppressive debt (No debt at a rate over 10 percent) | 0 | $ 0 | $ 0 | $0 |
| Approximate cash reserve (checking + savings) | Monthly income × 7 | $ 35,000 | $ 35,000 | $0 |
| Approximate other (jewelry, cars, furniture) | Monthly income × 7 | $ 35,000 | $ 35,000 | $0 |
| Approximate mortgage | Monthly income × 35 | $(175,000) | $(195,000) | $(20,000) |
| Approximate long-term investments (after tax) | Monthly income × 56 | $ 280,000 | $ 200,000 | −$ 80,000 |
| Approximate retirement savings | Monthly income × 91 | $ 455,000 | $ 300,000 | −$155,000 |
| Approximate total investment assets | Monthly income × 147 | $ 735,000 | $ 500,000 | −$235,000 |
Since they have accumulated $200,000, Brandon and Teresa could set up a line of credit for $100,000 (50% of $200,000). I recommend that they borrow less than $50,000. Let's assume that they want to buy a $40,000 car and that their borrowing cost is 4 percent. Table B.2 compares Brandon and Teresa to Amy and Bill who decide that they want a traditional car loan, also at 4 percent, amortizing over four years. Let's assume the following:
Table B.2 Brandon and Teresa vs. Amy and Bill—7 Years after Midpoint of Equilibrium
| Goal/Bucket | Beginning Balance | Brandon & Teresa Ending Balance after 7 Years | Amy & Bill Ending Balance after 7 Years |
| No oppressive debt (No debt at a rate over 10 percent) | $ 0 | $0 | $0 |
| Approximate cash reserve (checking + savings) | $ 35,000 | $ 35,000 | $ 35,000 |
| Approximate other (jewelry, cars, furniture) | $ 35,000 | $ 35,000 | $ 35,000 |
| Car loan | ($ 40,000) | ($ 40,000) | $0 |
| Value of car | $ 40,000 | $ 10,000 | $ 10,000 |
| Approximate mortgage | ($195,000) | ($195,000) | ($195,000) |
| Approximate long-term investments (after tax) | $200,000 | $364,4261 | $323,5622 |
| Approximate retirement savings | $300,000 | $533,6593 | $533,6594 |
| Approximate total investment assets | $500,000 | $898,085 | $857,221 |
| Investment assets + Car – Car loan | $868,085 | $867,085 |
Notes:
1 $200,000 at 7 percent (3 percent inflation + 4% return = 7%) for 7 years grows to $321,156.30. They have $3,000 of after tax savings. They have a “car budget” of $300 per month, or $3,600 per year. Their interest expense on the car is $40,000 × 4% = $1,600 so they have excess cash flow of $2,000. The Value of Debt is about better ways to pay for things you can afford, not ways to buy things you can't afford. Therefore, they choose to save the additional money, meaning that they save $5,000 per year. $5,000 per year at 7 percent for 7 years is $43,270.11. Therefore, their total portfolio is $321,156.30 + $43,270.11 = $364,426.41
2 $200,000 at 7 percent (3 percent inflation + 4% return = 7%) for 7 years grows to $321,156.30. They have $3,000 of after-tax savings. They have a “car budget” of $300 per month, or $3,600 per year. Their car payment on $40,000 at 4% for 4 years is = $903.16. The car budget of $3,600 + the $3,000 of cash for excess savings = $6,600. Since $903.16 × 12 is $10,837.92, they have a negative savings of $4,237.92 per year for the first four years. This “negative savings” is going toward paying down the car so they likely feel that they are “doing the right thing” by paying down debt. The “negative savings” reduces the value of their portfolio by $18,812.53. At the end of four years, they again begin saving $3,000 per year, plus they freed up the cash from the car budget of $300 per month ($3,600 per year) so they save a total of $6,600 for the final three years. This grows to a total of $21,218.34. Therefore, their total portfolio is $321,156.30 – $18,812.53 + $21,218.34 = $323,562.11
3 $6,000 per year at 7 percent for 7 years grows to $51,924.13. $300,000 existing assets at 7 percent for 7 years grows to 481,734.44. The total is $51,924.13 + 481,734.44 = $533,658.57.
4 Same formula as footnote 3.
- Portfolio return: inflation + 4 percent
- Inflation: 3 percent
- Time horizon: 7 years
- Value of car at end of 10 years: $10,000
- Savings rate: $9,000 ($6,000 to retirement accounts)
- Cash flow available for car payment: $300 per month
Individual specific assumptions:
- Cost of securities-based line of credit: 4 percent
- Amount of principal paid down on car loan: $0
- Cost of car loan: 4 percent
- Amortization period of car loan: 4 years
Notice, I held all of the assumptions the exact same in both scenarios. This is why you would expect the final answer to be very similar. And that is my point: You don't have to pay down your debt to increase your net worth. You can increase your net worth by building up assets. Brandon and Teresa enjoyed more flexibility, more liquidity, and more freedom—and have a little more money in their pocket. Due to their savings and some investment gains, their net worth was rising considerably during the seven-year period: an increase of $368,000—even though they didn't pay down a dime on their car or their house. This is the power of debt.1
The Power of Securities-Based Lending
If you live in the United States, you've been programmed to want to buy things since you could understand language (and possibly before). There's nothing wrong with that, as long as you're fully aware that “things” will never make you happy if you're not happy already. As long as you're not living beyond your means, you have a right to acquire some of the better things in life—and believe it or not, careful and responsible use of debt may help you do that. Once you understand how debt works—and how to work it—you can begin to make use of working and enriching debt to finance cars, homes, raw land, horses, boats, or whatever luxury items you desire. SBLs are not just about rate, they are about flexibility. A few quick examples:
- $300,000 boat × 4% = $12,000 per year in interest expense, $1,000 per month
- $200,000 lot to build a house × 4% = $8,000 per year in interest expense, $667 per month
- $50,000 advanced degree × 4% = $2,000 per year in interest expense, $167 per month
- $40,000 car × 4% = $1,600 per year in interest expense, $133 per month
- $20,000 new home furnishings and moving costs × 4% = $800 per year in interest expense, $67 per month
- $10,000 jewelry × 4% = $400 per year in interest expense, $33 per month
The prize on the other side of Equilibrium is tremendous. Brandon and Teresa will have tremendous financial flexibility. They could sell down $40,000 from their portfolio and pay off their car loan. They would still have an investment portfolio of $324,000, which would be eligible for a $160,000 line of credit. They could, for example, buy a $50,000 car (which, with the $10,000 trade-in would cost $40,000) and do a combination of new furnishings, jewelry, etc. They can now afford these luxuries. They have saved, and now they should enjoy—but of course, within guidelines and limits.
Before embracing securities-based lending, it is important to start with some important principles:
- The value of an item is 100 percent independent of the financing for that item.
The value of an item remains the same whether you pay cash, take out an amortized loan, or finance it through an SBL. The value you receive upon selling the asset has nothing to do with whether you have a loan against it. Your house—or a vacation home, a Renaissance painting, a rare coin collection—will either appreciate in value or depreciate in value, regardless of how it's financed. This important root principle allows you to think more holistically and creatively about financing opportunities.
- Amortization stinks!
Amortization requires the borrower to repay parts of the loan over time. What's wrong with this? An inflexible minimum monthly payment (including both interest and principal reduction) that you have to make no matter what else is going on in your life decreases liquidity just when you need it most. You're locked in until that loan is paid off. Your capital is tied up in fixed assets, and you can't put that money into savings and investments. Avoid these loans whenever possible.
- Mortgages trump SBLs all day long.
I refer to securities-based lending often because I believe it's a fantastic tool for people who have the assets and can use the facility responsibly. I talk about it a lot during trainings with financial advisors across the country, and I've become known as the “SBL Guy.” That's funny because, all things being equal, I'd always rather see my clients take out debt against their homes than against their portfolios.
A mortgage is considered permanent debt because you're locked in as soon as the bank wires the money. You own the house, and you'll lose it only if you stop making payments. Even if the home's value falls below the amount of the loan—which is what happened to a lot of homeowners during the housing crisis of 2008—you will not lose your home unless you stop making payments.
When you borrow against a portfolio, banks typically require you to maintain a certain percentage of collateral above the amount you've pledged to the line of credit. If you draw a high amount and the market falls, the bank can require you to pay down the loan with outside assets or it can legally sell off your securities—in a down market—to make up the difference. No one wants that.
When I was a financial advisor, I would almost always recommend that clients finance their homes through mortgages—which also have tax advantages—and use SBLs for bridge financing; buying cars, boats, and other luxuries; or emergencies.
First Bank of Mom and Dad
While you may not currently have assets that qualify for a line of credit, if your parents have an investment portfolio and are willing to help you out, there is a way to lessen your debt burden with lower interest and more flexible terms, freeing you from required monthly amortized payments. Using an SBL, your parents can borrow against their portfolio to pay off your credit card debt or student loans while continuing to invest their own assets.
Though you and your parents may choose to work out a monthly payment plan, you have the option of paying small amounts or interest only on an SBL—or nothing at all—without racking up penalties and fees while you're getting on your feet. Instead of juggling several different lenders with differing terms and interest rates, you'll be able to track just one loan with flexible terms. And you can always increase the payments or even pay off the entire loan once you find your dream job.
How does this work? Let's say you had a tough time finding a job and racked up $25,000 on your credit card at 20 percent interest (unfortunately, this is all too easy to do). At this rate, you're looking at paying $5,000 a year in interest, or over $400 per month in interest alone, on the card if you don't pay it off. If your parents have a $250,000 investment portfolio eligible for a line of credit against it, they can use the SBL facility to pay off your credit card at closer to 4 percent interest. Instead of owing $5,000 in interest a year, you owe $1,000 per year, or $83.33 a month ($25,000 × .04 = $1,000/12 = $83.33). Right off the bat, you're saving about $4,000 a year. And because the loan is not amortized, you can skip a few payments while you get settled into your new career—without penalty.
You can use securities-based lending to finance virtually anything and everything except the purchase of more securities. Typically, there is no cost to set them up, no ongoing fee, and no downside to having one in place. But make no mistake, these lines are not for everyone. You must be adequately invested in a portfolio that's strategically balanced across asset classes and countries before you borrow against it. And you must thoroughly understand the potential risk. Have sufficient cash to cover the loan in an emergency and never borrow more than 25 percent of your portfolio's value.2