Tips to consider if you’re planning for a big expense
Making smart cash flow choices for your financial life isn’t always straightforward if you’re unsure of the direction the market may go.
One fundamental way to make financial decisions easier is to look at the potential cost versus benefit. For example, are you facing a large expense, such as a large tax bill, a residential or commercial real estate transaction, or something else? Now is the time to consider the impacts of borrowing versus liquidating assets to cover those costs.
Even when interest rates are rising, both approaches can be worth considering. Borrowing may provide the opportunity to handle an emergency or make a major purchase at a discount without disrupting a portfolio in the short term.
“Just having quick access to liquidity or a line of credit can be important,” says Jessica Kelly, a business growth strategy director for Wells Fargo Advisors.
With that in mind, here are some cash flow considerations:
Borrowing versus liquidating assets
When faced with cash flow needs, individuals should explore all the lending options available to them, says Trisha Knake, head of securities-based lending with Wells Fargo Wealth & Investment Management, Wells Fargo Bank, N.A. Both Kelly and Knake agree that borrowing to pay off a tax bill, for example, could be a better option than selling assets to cover the expense, particularly if the sale would mean sacrificing potential investment earnings plus creating a capital gains tax expense. It’s important for individuals to consult their tax advisors and investment professional before taking any action that may involve tax consequences.
“Sometimes it may be correct to liquidate or use cash depending on your situation,” Kelly says. “But if the rate you can borrow money short term is lower than your rate of return on your portfolio’s investments long term, that could work to your advantage. For clients who are not borrowing long term, that could make sense for them. It comes down to time in the market versus timing the market.”
When it comes to borrowing, harnessing the value of your investment account could be worth considering. Securities-based lending (SBL) is an option that uses securities such as stocks, bonds, and mutual funds as collateral, and it could help you meet your liquidity needs.
“A securities-based credit line typically comes at a more attractive interest rate than an unsecured loan or a loan against less liquid collateral,” Knake explains.
Kelly agrees. “SBL rates tend to be lower than other variable-rate credit lines, plus they aren’t typically reported to credit bureaus.”
Knake and Kelly describe these potential advantages of securities-based borrowing:
- Quick access to cash while potentially avoiding capital gains taxes from selling securities
- Typically lower rates compared with other forms of borrowing, such as credit cards
- No setup, nonuse, or cancellation fees
- Ability to borrow up to 50% to 95% of your eligible asset value, depending on the collateral type
But SBLs do have risks. “One downside is the risk of a margin call, in which the lender may require the sale of some or all of a client’s securities.” Knake says. (A margin call is issued when the value of the collateral falls below the amount required by the lender to support the loan.)
If a client’s securities are sold due to a margin call, the sale may cause them to suffer adverse tax consequences. Keep in mind, SBL has special risks. Margin borrowing and SBL may not be appropriate for everyone. If interest rates rise, it will affect the client’s overall cost of borrowing, and there may be limitations on what you can use the line of credit for.
Paying cash to cover expenses
In some instances, it can make sense to pay cash instead of borrowing. “If someone has a fair amount of cash and is not planning to invest that cash, that could be the better solution to pay for things, including a car, a house, a child’s education, or the expansion of a business,” says Knake. “It’s not a one-size-fits-all, so it’s important to work with an advisor to review an individual’s assets versus their liabilities in order to determine if paying cash makes the most sense.”
Other reasons to use cash include not having access to enough credit or simply being debt-averse.
Think of assets and liabilities like a CFO
It can help to put yourself in a chief financial officer (CFO) mindset when determining how to help achieve your goals while managing your cash flow. For example, CFOs typically take a holistic balance sheet approach that includes account assets (equities) and liabilities (borrowing).
“If you look at most corporations, they’re comfortable with a certain amount of leverage (borrowed capital) to optimize their balance sheets,” Knake says. “And many of our high-net-worth clients could look at their overall balance sheet to see how they can optimize it by reviewing both assets and liabilities together. That can mean comparing the cost of borrowing versus the cost of liquidating or staying invested and using this comparison to help inform their decisions.”
Regardless of what individuals decide to do next, Knake and Kelly say they should carefully review all of their options.
“Individuals have dreams, hopes, and goals, and there are ways to help fund them even during times of market uncertainty,” Kelly says. “You just have to decide the best option for you, which can be made clearer by having those conversations with your advisors.”
Wells Fargo Wealth & Investment Management (WIM) provides financial products and services through various bank and brokerage affiliates of Wells Fargo & Company.
Wells Fargo & Company and its affiliates do not provide tax or legal advice. This communication cannot be relied upon to avoid tax penalties. Please consult your tax and legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your tax return is filed.
Securities-based lending has special risks and is not appropriate for everyone. If the market value of a client’s pledged securities declines below required levels, the client may be required to pay down his or her line of credit or pledge additional eligible securities in order to maintain it, or the lender may require the sale of some or all of the client’s securities. Wells Fargo Advisors will attempt to notify clients of maintenance calls but is not required to do so. Clients are not entitled to choose which securities in their accounts are sold. The sale of their securities may cause clients to suffer adverse tax consequences. Clients should discuss the tax implications of pledging securities as collateral with their tax advisors. An increase in interest rates will affect the overall cost of borrowing. All securities and accounts are subject to eligibility requirements. Clients should read all lines of credit documents carefully. The proceeds from securities-based lines of credit may not be used to purchase additional securities, pay down margin, or for insurance products offered by Wells Fargo affiliates. Securities held in a retirement account cannot be used as collateral to obtain a loan. Securities purchased in the pledge account must meet collateral eligibility requirements.
Wells Fargo Advisors (“WFA”) and its Financial Advisors have a financial incentive to recommend the use of securities-based lending products (“SBLs”) rather than the sale of securities to meet client liquidity needs. Financial Advisors will receive compensation on Priority Credit Line (“PCL”) and other non-purpose SBL from Wells Fargo Bank. Your Financial Advisor’s compensation is based on the outstanding debit balance in your account. In addition, your Financial Advisor’s compensation will be reduced if your interest rate is discounted below a certain level. This creates an incentive for Financial Advisors to recommend PCL and other SBL products, as well as an incentive to encourage you to maintain a larger debit balance and to discourage interest rate discounts below a certain level. The interest you pay for the loan is separate from, and in addition to, other fees you may pay related to the investments used to secure the loan, such as ongoing investment advisory fees (wrap fees) and fees for investments such as mutual funds and ETFs, for which WFA and/or our affiliates receive administrative or management fees or other compensation. Specifically, WFA benefits if you draw down on your loan to meet liquidity needs rather than sell securities or other investments, which would reduce our compensation. When assets are liquidated pursuant to a house call or demands for repayment, WFA and your Financial Advisor also will benefit if assets that do not have ongoing fees (such as securities in brokerage accounts) are liquidated prior to, or instead of, assets that provide additional fees or revenues to us (such as assets in an investment advisory account). Further, different types of securities have higher release rates than others, which can create a financial incentive for your Financial Advisor to recommend products, or manage the account, in order to maximize the amount of the loan.
Return figures and rates mentioned are shown for illustrative purposes only and do not reflect any actual returns or rates available through Wells Fargo.
Margin borrowing may not be appropriate for all investors. When you use margin, you are subject to a high degree of risk. Market conditions can magnify any potential for loss. The value of the securities you hold in your account, which will fluctuate, must be maintained above a minimum value in order for the loan to remain in good standing. If it is not, you will be required to deposit additional securities and/or cash in the account or securities in the account may be sold. Clients are not entitled to choose which securities in their accounts are sold. The sale of their pledged securities may cause clients to suffer adverse tax consequences. Clients should discuss the tax implications of pledging securities as collateral with their tax advisors. An increase in interest rates will affect the overall cost of borrowing. Margin strategies are not appropriate for retirement accounts. Please carefully review the margin agreement, which explains the terms and conditions of the margin account, including how the interest on the loan is calculated.
