Real Estate: to Buy or to Borrow?

This article originally appeared in Aldrich Community, a client experience offering from Aldrich Wealth.

At the end of the first quarter of 2022, the market was abuzz with news of increasing interest rates. As borrowers, we know that as rates rise, it costs us more in interest to borrow the same amount of money. Naturally, potential buyers would rather avoid higher borrowing costs for a new home by paying with available cash or proceeds from their current house. We recently met with clients to discuss liquidating their portfolio. Their goal was to make an all-cash offer on their dream home, which they knew would be off the market before they could sell their current house and get the money they needed. “As you know,” they said, “Cash is king!” While the old adage has its merits, especially in a seller’s market like we see today, we offered some alternatives to bridge the liquidity gap that didn’t require choosing between their forever home and their nest egg. These four strategies, while less commonly discussed, can be very helpful. This article aims to provide an explanation of each strategy and hope that your next home is not out of reach!

You may have ample funds available in your investment accounts to make a down payment or an all-cash purchase without sacrificing retirement spending goals, but you might still be better off staying invested and using leverage instead.

If you’re unfamiliar with the concept of leverage, it helps to start by looking at how traditional loans are structured. With traditional loans, you put some skin in the game by making a down payment, and then lenders give you access to their capital in exchange for the house as collateral. If you default, they can take possession of the property. Leverage also allows investors to borrow against collateral, but in this case, investment accounts serve as collateral instead of property. There’s more than one way to leverage your investment account, and we’ll share two methods here. It’s worth noting that both leverage options are more often used for short-term liquidity needs and that there can be additional restrictions to collateralize retirement accounts such as IRAs.

Margin:
By adding margin to your investment account, you can take out a loan from the custodian equal to a certain percentage of the account balance, often 50%. Margin loans don’t require scheduled monthly payments. Instead, you’re only required to make payments, or margin calls if the account value declines by a certain percentage, which can happen as a result of withdrawals or fluctuations in investment valuations. In the meantime, depending on your custodian, it is possible that any cash that comes into the account (dividends, interest, capital gain distributions) may be automatically debited and applied toward the debt. Margin rates, while variable, tend to be lower than traditional mortgage rates because the collateral (your investments) is liquid, and the lender already has custody of it. As a bonus, margin loans don’t require the lengthy paperwork and approval processes traditional borrowers face. Margin can be set up to disburse funds in 2-3 business days, enabling a quick cash offer that can beat out the competition.

Pledged Asset Line (PAL):
Pledged asset lines (PALs) also collateralize investment assets, but there are some notable differentiators from margin. A PAL is a separate account set up with the number of investments that you wish to collateralize. With a PAL, you can typically borrow up to 60-70% of the collateralized investments. The interest on PALs can either be fixed or floating-rate depending on the borrower’s preference, and repayment options are flexible so that if you’d prefer to make steady mortgage-like payments, you can do so. That said, account income won’t automatically be applied to the loan balance as you’d see with margin loans. PALs also require more paperwork and oversight to set up than margin, so it may take as long as 4-5 weeks to set up and disburse funds.

If you’re more comfortable collateralizing your home than your investment assets, that doesn’t mean you’re out of luck if you need short-term liquidity. Below, we highlight a few ways you can tap into your home equity to make the cash available.

Cash-Out Refinance:
Many homeowners refinanced existing mortgages in recent years to take advantage of historically low-interest rates. While the window to lock in lower rates may already be closed, that’s not the only reason to refinance. A “cash-out refi” is another great tool to create liquidity. Essentially, you can refinance at available market rates and pull out 80% of your existing home’s value in cash. This gives prospective buyers the freedom and liquidity they need to make a down payment or cash offer without relying on selling their current home first. Eventually, when you sell your original home, you’ll use the proceeds to wipe out the additional mortgage debt.

Line of Credit:
If you aren’t sure exactly how much cash you’ll need, the home equity line of credit (HELOC) might make sense for you. Similar to a cash-out refinance, the HELOC collateralizes your home to make a certain amount of funds available to you. With a HELOC, you’re not obligated to withdraw the entire amount available. In fact, you’re only charged interest on the funds you borrow. Unlike the refinance, HELOCs don’t require scheduled principal payments for the first several years; however, you will be required to make interest-only payments during that time. Even so, given that rates are variable and may increase in the future, this tends to be a short-term cash solution. As with the cash-out refinance, the HELOC is wiped out at the sale of the home using proceeds.

You may be asking, “Why tap into my home equity if I have investments I can sell to meet my need?” The answer is two-fold.

1. Given the incredible appreciation in home values we’re seeing, cash-out refinancing or lines of credit can create significant liquidity for borrowers.
2. Current mortgage rates and even HELOC rates may very well be below the expected growth of your portfolio over time, meaning your investments could earn more than it costs you to fund your cash need via refinancing or a HELOC. Of course, your decision should be informed by expected returns for your specific investment allocation. You should also account for up-front costs of borrowing, for example, the lender fees and closing costs associated with a refinance.

In short, cash may be king, but there is more than one way to access capital when the need arises. Even if you have sufficient liquid investments, debt can potentially be a better means of financing a big purchase or providing a short-term solution to a lack of liquidity. Of course, whether that makes sense for you depends on current market conditions and ultimately your feelings about debt. If you have questions about the best way to finance a purchase, our team of trusted advisors is here to help you understand all the tools at your disposal so you can make a fully informed decision.