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Especially in times of low interest rates, optimal solutions may not be the most obvious ones. Here’s why borrowing may make more sense than liquidating long-term investment assets or depleting cash reserves earmarked for other short-term needs.
Why Borrowing Is an Investment Decision Infographic PDF
March 2, 2021
Borrowing is typically seen as a money or debt decision. In reality, it’s an investment decision.
That’s because borrowing –– especially in times of low interest rates –– may make more sense than liquidating long-term investment assets or depleting cash reserves earmarked for other short-term needs. When borrowing is done right, it can actually add to your existing investments and grow your overall wealth.
In today’s historically low interest rate environment, clients who strategically utilize leverage are well positioned to enhance their investment returns. We can quantify just how using leverage can enhance returns by looking at two different clients: Sam, who liquidates his portfolio to spend, and Gloria, who borrows to spend.
Both clients start with a $20 million portfolio that holds unrealized capital gains of 10% and a $4 million spending need (think taxes, luxury items, home improvement vs. corporate operations). We assume a fully diversified, moderate growth allocation, and our 2021 capital market assumptions.
In the “liquidate” portfolio, we sold off $4 million worth of investments to meet Sam’s spending needs, and applied a federal tax rate of 23.8% to the unrealized gains on this portion of the assets, which was equal to 20% of the total portfolio.
In the “borrow” portfolio, we left Gloria’s portfolio fully invested and, by leveraging it as collateral for a line of credit, she was able to borrow $4 million over a five-year period. We assumed interest on the line at the current fed funds rate, with a 150-basis point margin and a 2% floor. At the end of the five-year period, we repaid the loan in full.
We compared the returns of the two portfolios at the end of five years.
The conclusion of this analysis was that Sam’s portfolio ended up at $20.4 million after five years, just slightly above where it began, while Gloria’s grew to $21.3 million. The return differential after the five-year period was a cumulative 4%, or 0.8% on an annualized basis. When compared to a portfolio return of 5.15% for a moderate growth portfolio, this 0.8% “alpha” represents an additional 15% to annual return. And, at 20% leverage against her portfolio, the client is unlikely to experience a collateral call even in the worst of market conditions.
This is just one way to demonstrate the value of borrowing — how it can enhance portfolio returns by replacing the need to liquidate portions of the portfolio and leaving asset allocation strategy in place. We also looked at a pure leverage play in which the client borrows not to spend, but to invest. And, although the savings of capital gains taxes would not factor into this scenario, the client can still benefit from the arbitrage between portfolio returns and loan interest rates.
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