The Pros and Cons of Borrowing Against Your Stock Portfolio in Retirement

As we’ll show in this article, borrowing against your stock portfolio is a lot quicker, more tax-efficient, and has significantly less closing costs than getting a traditional loan from your bank.

Anyone who has purchased a home is familiar with the concept of leverage. Most people when they purchase a home use 20% of their own money and borrow 80% from the bank. If the amount of appreciation on the home is more than the cost of the loan (and other costs of home ownership), then the investor makes money on the transaction.

What most investors and pre-retirees don’t realize is that they can borrow against their investment portfolio with more preferential advantages. By keeping their investments growing and compounding at a higher rate than the after-tax cost of the loan, investors can avail themselves of numerous financial planning opportunities while creating more after-tax wealth for themselves and their beneficiaries.

We also note that borrowing against your equity portfolio instead of shifting your assets away from your equity portfolio towards bonds, allows for significantly better retirement outcomes.

Shifting the client’s portfolio from stocks to bonds in retirement hurts long-term wealth

If you’re invested in a target date fund through work or working with a financial advisor and ask them about their asset allocation strategy for you as you prepare retirement, they’ll tell you that their plan is to invest heavily in equities when you’re young in order to maximize growth and then shift towards a significant bond allocation as you get older to minimize downside risk. However, as we’ve shown in a previous blog post, this allocation model benefits their business model has significant drawbacks to both meeting retirement income needs as well as the after-tax wealth left to beneficiaries.

This makes intuitive sense if we think about it. If our stock portfolio is earning 8% and we’re shifting away from that towards a bond portfolio that is earning ~4%, that’s going to have an effect on long-term wealth creation.

Shifting the portfolio allocation away from higher-earning, tax-efficient equity portfolios towards lower earning, tax-inefficient bonds ends up preventing the accumulation of long-term wealth with limited benefits towards downside protection and retirement goals—especially if you’re in high tax brackets.

In this article we’ll show why keeping a heavy equity allocation while borrowing against your investment portfolio through margin borrowing instead of investing in bonds and making a taxable withdrawal each year can lead to significant after-tax wealth in retirement due to the difference between the rate of the loan, the rate of return in the portfolio, and the value of the step-up in basis provision that allows beneficiaries to keep gains tax-free.

An important point to note here is that we are not using maximum leverage in order to maximize returns because that comes with significant risk. Rather, we are using the minimum leverage needed each year to make withdrawals using loans so that we don’t have to make taxable withdrawals. So instead of borrowing 80% of the value of your home like you would do with a home purchase using maximum leverage, you’d only be borrowing ~4%-6% of the value of your portfolio each year.

What is borrowing on margin (borrowing against securities)?

Borrowing against your investment portfolio  (also known as borrowing on margin) is when an investor takes a loan against the value of his investment portfolio. We can think of this similar to refinancing your home. If your home is paid off and the current market value is $1M, a bank will typically allow you the ability to borrow ~80% of the market value of the home in exchange for you paying a monthly payment towards paying off the loan.

With borrowing on margin, instead of borrowing against the value of the home, you are a borrowing against the value of your investment portfolio. The key difference here is that unlike a mortgage, there is no required monthly repayment like you have with a mortgage. There are also no loan fees, or income and credit requirements on behalf of the borrower since the lender is not requiring the borrower to repay the loan in cash. All that matters is the value of the portfolio that is being used as collateral—not the credit worthiness of the individual taking the loan. Furthermore, the rates for borrowing against your portfolio are close to current mortgage rates as indicated in the table below. However, it’s important to note that mortgage rates are typically locked in for 15 or 30 years, whereas securities loans are variable and dependent on the current interest rate environment at the time. While this means a higher interest rate in a high interest rate environment (like in 2023), it’s low in low interest rate environments (eg 2015-2021).

Current securities borrowing rate vs current mortgage rates

However, since securities borrowing doesn’t require a monthly loan repayment the way a mortgage does, the brokerage firm issuing the loan requires the borrower to ensure that the value of the loan never exceeds a certain percentage of the value of the borrower’s portfolio. This percentage is based on the overall risk of the borrower’s investment portfolio. If the borrower’s investment portfolio consists of exclusively diversified equity index funds, for example, this percentage will be around 70%. If the borrower’s portfolio, on the other hand, consists of just one individual stock, this percentage will be significantly lower. On the other hand, if the borrower is only invested in standard S&P500 index funds, this percentage will be as high as 85%.

As long as the borrower keeps this percentage below the maximum percentage allowed, the borrower is not required to make a loan payment to pay down the loan.

However, if the value of the investment portfolio drops, then the brokerage firm will require the borrower to make an immediate loan repayment (known as a margin call)—otherwise they will sell some of the borrower’s stock to cover the difference.

Let’s look at an example.

Example 1:

John has an investment portfolio of $1 million with his brokerage firm invested in a diversified equity index fund. The brokerage firm will allow John to borrow a maximum of 70% of the value of his investment portfolio. On the morning of May 1^st John decides to borrow the maximum amount from his portfolio which is $700,000 at 6% interest. At the end of the day John’s portfolio drops by 2% from $1M to $980,000. At the end of the day John’s loan balance with interest is $700,117. His loan-to-value is now 71.44% ($700,117/$980,000=71.44%). This means that John’s current loan-to-value is higher than the maximum 70%. In order to get his percentage back down to 70%, John can do one of two things:

1. Pay back $14,167 in cash to get his loan-to-value percentage down to 70% ($686,000/$980,000=70%)
   
2. Sell $47,343 of his equity index fund and use that to pay down the loan balance ($652,734/$932,657=70%)

If John doesn’t do either of these in 2-5 days, his brokerage firm will automatically do #2 on his behalf.

This is the danger of being over-levered and utilizing the maximum leverage percentage. Unless John wants to run this risk, or has extra cash available to pay down the loan at any point, it’s safer for him to use a lower amount of leverage to give himself a buffer in case his portfolio takes a hit. Utilizing safer borrowing ratios of 40%-50% instead of the maximum 70% can help avoid this.

Another huge benefit of using margin interest is that if the borrower pays the interest on the loan, the loan interest is fully tax deductible against his net investment income. This differs from a home mortgage where only interest on the first $750,000 of loan principal is deductible (and second mortgages are not deductible at all).

Furthermore, the tax-deductibility on the loss can be carried forward (and even backward for a limited number of years) to offset future gains indefinitely. There is no limit on the amount of margin interest deductions that can be carried forward. This is a huge gain over the tax-deductibility of interest on a primary residence where the interest deduction can only be carried forward 3 years.

The table below summarizes some of the key differences between borrowing against the value of your home versus against your investment portfolio.

Mortgage loan versus Securities loan

Utilizing margin loans instead of taking taxable withdrawals

The goal of using leverage in retirement is to allow your portfolio the ability to continue to grow at higher rates while borrowing at lower rates—without using so much leverage that it puts your portfolio at risk. The more your portfolio grows in the earlier years, the more you have to spend later in retirement—or pass on tax-free to your heirs through step-up in basis.

The easiest way to see the value of using a higher equity portfolio is to compare the retirement goals of two different couples. One uses a 100% equity portfolio, utilizing leverage for their withdrawals in retirement versus another couple that uses a traditional 60% equity/40% bond portfolio and uses taxable withdrawals for their retirement income.

We can see this in the following example.

Example 2:

John and Sally are a married couple both age 55 living in California. They have a $2.8M portfolio and plan to take out $200k/year in retirement starting from age 65. They are currently invested in a target date fund with a 60/40 portfolio with an expected return of 8% for the stock side of the portfolio and 4% for the bond side of the portfolio that is rebalanced once a year.

David and Mary are also a married couple both age 55 who also have a $2.8M portfolio and live in California. They also plan to spend $200k/year in retirement from age 65. However, they realize that bonds are highly taxable, with low expected returns in comparison to stocks. As such they decide to invest in 100% equity portfolio and use margin loans from their broker at 6.5% to make their yearly withdrawals of $200k. This allows their equity portfolio to compound more without the drag of taxes and rebalancing.

Which couple has a higher chance of meeting their retirement income goals? Which couple leaves more after-tax wealth to their heirs?

We can answer that by doing a simple Monte Carlo simulation on both strategies as well as comparing that to an equity portfolio using just 100% equity portfolio with taxable withdrawals.

Monte Carlo simulations using taxable and margin loan withdrawals with various equity allocations

There are a couple of takeaways from the table above:

1. Using as all equity portfolio increases the median after-tax wealth left to heirs
Comparing rows 1 and 3 from the table above, we can see that using an all equity portfolio with taxable withdrawals has a higher median fund value than that of the 60/40 portfolio at both age 65 when the client starts taking withdrawals and at age 95.

At age 65, the client has 14% more wealth by choosing the 100% equity portfolio with taxable withdrawals over the 60% equity/40% bond portfolio ($5,605,313 vs $4,906,423).

By age 95 this amount has increased to 175% more wealth ($16,705,896 vs $6,072,735).

The reason for this drastic amount of wealth difference is that by investing in a higher-earning, more tax-efficient equity portfolio, as opposed to the lower-earning, tax-inefficient bond portfolio, the client is able to accumulate significantly more wealth over the long-term.

The all equity portfolio with taxable withdrawals also has a slightly higher chance of meeting the retirement income goals of the client (82% vs 77%) although the risk-adjusted return is also lower as seen through the lower after-tax Sortino ratio (1.66 vs 2.03). So while the equity portfolio is providing more return, it’s also providing more risk to the client.

2. Using loan withdrawals increases median after-tax wealth, but also severely increases the risk of the portfolio
If we compare the all equity portfolio using taxable withdrawals (Row 2) versus the all equity portfolio using margin loan withdrawals (Row 3) we notice that median after-tax wealth has increased—but so has the risk of the portfolio.

The downside with using loans as withdrawals with 100% equity portfolio as opposed to using a 60/40 portfolio with taxable withdrawals is that the chance of meeting the retirement income goal is reduced (69% vs 77%).

The reason for this is that in a few scenarios with the 100% equity portfolio, the loan to value ratio equaled 70% at some point in retirement and the client therefore would have had to cut some or all of their retirement income in that year in order to allow the loan-to-value ratio to drop back down to 70%.

This is why the after-tax Sortino ratio for the 100% equity portfolio with margin withdrawals is so low.

If the client doesn’t want the use of leverage to increase their risk of not being able to meet their retirement goals, they can also utilize a 100% equity portfolio with taxable withdrawals (3^rd row on the table above).

So the catch here is that if clients are planning on utilizing margin withdrawals, then they may have to reduce their retirement income spending from their initial income goal if the loan to value ratio starts to creep up to that 70% loan-to-value limit.

Another interesting question to ask here is:

The only advantage the 60/40 portfolio has is that it has a higher chance of meeting the original retirement income goal of $200k per year (77% vs 69%).  What other parameters can we change here such that the 100% equity portfolio using margin withdrawals has the same 77% chance of meeting the retirement income goal?

The table below helps answer that question.

Chance of meeting retirement income goal at 77% under the 100% equity portfolio with margin loans after changing different parameters

As the table above shows, by relaxing certain parameters such as LTV or loan rate, the chance of meeting the retirement goal can be increased to 77%. Or if the client wants to prioritize leaving wealth to their heirs, reducing the withdrawals from $200k to $172k would also increase the chance of retirement to 77%.

Of these options, changing the LTV ratio and the withdrawal rate are most likely solutions. Brokerage firms like Interactive Brokers allow you to borrow as much as 85% of your portfolio value if you invest in well-known and well-traded index funds like an S&P500 index fund.

The loan-rate cannot be changed as it is a function of the interest rate environment of the economy. However, it’s well worth noting that today we are in a high interest rate environment and the probability of the loan rate being lower than this is significantly higher than it being larger than this (it’s worth noting that during the 2015-2022 time period this loan rate was in the 1%-3% range).

Conclusion

Using margin loans to make withdrawals in retirement appropriately can help clients retain more wealth, leaving more to their beneficiaries. The only downside of this is that the likelihood of achieving the retirement goal reduces a little compared to the 60/40 portfolio.

Most of the larger custodians (like Vanguard, Schwab, Fidelity, Etrade, etc) don’t offer margin loans at competitive rates. Since most financial advisors use the larger platforms they can’t offer this at competitive rates. And even if they had access to affordable margin rates, margin loans often don’t fit within their business model.

So if you’re nearing retirement and looking to retire early by using this strategy, seek out a financial advisor who does offer them or do it yourself from one of the affordable brokerages listed below.

Margin rates on a $300k loan at different brokerages as of 11/21/2023