How Does a Portfolio Line of Credit Work?
A portfolio line of credit is issued by a brokerage firm rather than your bank. A brokerage firm’s key responsibility is to facilitate communication between buyers and sellers to allow for a transaction. The brokerage firm evaluates your portfolio and allows you to borrow up to a certain percentage of its value.
Regulation T is a series of provisions that preside over investors’ cash accounts and the sum of money that brokerage dealers and firms may provide customers to buy securities. Regulation T allows investors to borrow up to 50% of a portfolio's value, but your brokerage may have lower borrowing limits.
Not all securities within a portfolio may be eligible for margin lending. Margin lending is a loan that lets you lend money to invest, by utilizing your managed funds, cash, or current shares as security.
Which Assets Qualify for a Portfolio Line of Credit?
The brokerage firm charges interest based on how much you borrow and for how long. This process means that you'll pay interest monthly based on your average daily balance. However, you only pay interest when you use the portfolio line of credit.
A Drop in Value:
If your portfolio falls in value, your borrowing limit also adjusts. When you have a balance outstanding, a drop in your portfolio's value may affect your ability to borrow more money. Additionally, you may be subject to a margin call if the value drops too much.
A margin call:
A margin call is when the brokerage informs you that you need to pay down your balance or add more assets to keep your account in good standing. If you fail to do so or your portfolio value drops further, the brokerage firm can sell assets to cover the loan and bring it back into compliance. Some brokerages allow you to pick which assets to sell, while others do not.
If you or your brokerage sells assets to satisfy a margin call, this can make your financial situation worse. Not only are you selling assets when their value is down, but this may also trigger a taxable gain. Having a larger than necessary tax bill can further crimp your finances.
What Can a Portfolio Line of Credit be Used For?
Purchase inventory - businesses need inventory to generate sales, but it can be difficult to accumulate the initial seed money. Some business owners also look into business credit card funding for this purpose.
Consolidate debt - many business owners find it easier to make one payment than to remember making payments to multiple creditors.
Expand the business - opening a new location or expanding your current one costs money. These costs add up quickly between the initial security deposits, tenant improvements, equipment, supplies, and more.
Cover payroll - employees are the lifeblood of a business, so they need to be paid even if cash flow is tight.
Take advantage of early payment discounts - some suppliers offer a discount if their invoices are paid quickly. While you pay interest when using a line of credit, it can be worth it if the discount is large enough.
Applying for a home equity line of credit can take weeks since many lenders need to perform an appraisal before approving your application...
Benefits of Portfolio Lines of Credit
Quicker approval - a traditional business line of credit requires an application and underwriting by the bank. This process can take days or weeks. A portfolio line of credit is typically approved the same day.
No credit inquiry - whether you have bad credit or don't want an inquiry on your credit report, a margin loan avoids those concerns. Your credit isn't involved in the decision process as a collateralized loan.
Lower interest rates - interest rates on portfolio lines of credit are generally lower because your investments secure them. As there is less risk to the lender, they can offer lower rates.
Fewer fees compared to a bank - typically, there are no closing costs, annual fees, set-up fees, or non-use fees associated with securities-backed lending. Most banks charge one or more of these fees for their business lines of credit, even if you never use it.
Portfolio growth may increase line of credit - as your portfolio grows, your ability to borrow may also increase.
Risks Associated With Portfolio Lines of Credit
Margin calls can sell without your approval - if your investment values drop too low, the brokerage firm will step in and restrict trading. It may even sell your securities without your approval to cover a portion of the loan balance. Providing this authority to the brokerage firm is a condition of getting your portfolio line of credit.
Trading can be restricted - depending on the brokerage firm you're using. You may not be able to sell the assets that secure your line of credit. Additionally, the brokerage may prevent you from buying assets that are ineligible for margin.
Not all assets are eligible - with collateralized loans like a portfolio line of credit, the lender decides which assets qualify to secure your loan. Thinly traded securities, annuities, options, money market funds, CDs, offshore mutual funds, alternative assets, and similar investments are usually excluded.
Cannot use retirement accounts - to borrow with a portfolio line of credit, you must use a taxable brokerage account. Retirement accounts like a 401(k) or IRA are ineligible for borrowing. If you are looking for an alternative form of funding you might wish to look into an overdraft line of credit.
Tips for Using a Portfolio Lines of Credit
Smart use of your line of credit can enhance your business, allowing it to reach its potential while also increasing profits.
Here are a few tips for using your portfolio line of credit effectively:
- Keep borrowing to a minimum - any amount you borrow will have to be repaid using future cash flows. Only borrow when necessary and plan to repay the money before making a draw.
- Eliminate high-interest debt - by moving debt to a lower-interest loan, you can free up cash flow to operate your business more freely or accelerate the balance repayment.
- Make partial payments throughout the month - interest charges are based on your average daily balance. Making extra payments throughout the month can reduce the interest you are charged.
- Keep track of your portfolio - watching for changes in investment values will give you an early warning to your ability to borrow or need to satisfy a margin call.
Is a Portfolio Line Of Credit Right For Your Business?
Portfolio lines of credit are a quick and easy solution for business owners who are having trouble getting approved for a traditional loan. Your investment assets secure the loan without requiring you to sell them. This option avoids costly taxes and missing out on market growth.
As a small business, you have several choices for funding your business. These include a traditional business line of credit, an equipment line of credit, a home equity line of credit or a portfolio line of credit. Each type of loan has distinct pros and cons that you should consider before picking one over another.