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When to use your broker for borrowing

The recent rise in margin debt -- loans backed by investments -- could lead some to believe that speculation is rising in financial markets. But more investors may be using margin debt a affordable and easily accessible form of consumer credit, brokers and financial experts say. By Gayle B. Ronan.

When the major stock market indices returned to levels first explored during the bubbly days of 2000 last year, the level of outstanding margin debt — loans backed by investments — also returned to its previous heights.

It reached $270.52 billion in November 2006, according to the figures released last week by the New York Stock Exchange.  That is just shy of the March 2000 record of $278.53 billion when the stock market speculation it helped support reached its peak.

Despite returning to a level last associated with outright investor frenzy, there is a resounding absence of hand-wringing these days. Also missing: pundits warning of an impending market collapse brought on by leverage-wielding speculators using margin to buy stocks.

“That is because no one believes we have a speculative frenzy like we had back then,” says Herb Kaufman, professor of finance with the W.P. Carey School of Business at Arizona State University in Tempe.  “There are real economic reasons for the stock market’s recent advance, unlike in 2000-2001.”

Individual stock valuations are also viewed as reasonable. “Price-to-earnings ratios were a lot higher in 2000,” says Tom Tracy, a principal with Kochis Fitz, a San Francisco wealth manager. “Today’s levels do not indicate rampant speculation.”

But if the rising level of margin debt is not fueling speculation, what is it being used for? 

“No one seems to regularly collect data on how margin debt is used,” says Kaufman, who adds he would not be surprised if it turned out margin debt is finding increased use as a lower-cost — but riskier — alternative to other forms of personal credit. 

According brokerage firm Charles Schwab, "We do not track what our clients use margins for, nor do we actively market borrowing on margin as a source of funds for paying personal expenses to our clients. But margin accounts are an easy source of credit for personal financing needs,” says Glen Mathison, a Schwab spokesperson in San Francisco. 

Once you open a brokerage account, there is generally no extra paperwork required to borrow on margin. But if the shares in your account lose value suddenly, you could find yourself subject to a "margin call" in which your broker can sell stock out of your account to maintain the equity in your loan.

Favorable rates, easy access
Despite the risk, the ease of borrowing can be appealing. There are no processing fees, fixed repayment schedules, nor typically any minimums or maximums. A brokerage firm client simply makes a withdrawal. Even the rates are comparatively low.

For instance, Raymond James, like many brokers, provides a schedule of rates on its Web site and lists margin rates at, near or below prime — the higher the loan balance, the lower the rate.

As attractive as rates are, they are also negotiable.

Tracy says his firm has obtained rate concessions as high as 3 percentage points for its wealthiest clients.  For the less wealthy and those borrowing smaller amounts, Tracy advises: It never hurts to ask, or shop around.  Discount brokers periodically compete to attract new margin borrowers.

Margin interest may even be tax-deductible. However, the money must be used to finance an investment — not an engagement ring.

The low costs and ease of borrowing may lead some investors to view it as an alternative to other equity-based credit — such as loans backed by your home's value — for short-term needs.

“With a slowdown in the home-equity area, there may be a small subset of homeowners — those with non-retirement brokerage accounts — turning to their margin accounts for loans instead of their homes, given the very good year the stock market has had,” says Kaufman. 

Kaufman observes that in general, rising equity prices — whether in portfolios or in homes — tend to fuel consumer spending.

“We may also be seeing more willingness on the part of investors to use their invested assets to finance spending [today] vs. 2000,” says Kaufman. The increasing use of home equity over the ensuing years may have accustomed them to viewing all ‘equity’ as a source of financing.

Wealth advisers may also be playing a role in familiarizing investors with the use of margin debt as a wealth management tool.

In early December, Merrill Lynch sent a letter to some of its high net worth clients reminding them that short-term financing can be used to fund holiday purchases, make home repairs or  retire high-interest, credit card debt.

“Obviously this form of financing is not for everyone.  The clients who received the letter work with our wealth advisers and were screened for the appropriateness of the mailing,” says Jennifer Grigas, a spokesperson for Merrill Lynch. 

Not for everyone
“We look at borrowing on margin for our clients,” confirms Tracy. “It can make sense for short-term financing as long as it is the least expensive option available and the repayment sources are known,” he explains.

For instance, investors with well-diversified portfolios expecting bonuses in January could easily spend in December knowing they are likely to have the money to retire any margin debt quickly. “But borrowing against a brokerage account is not a good substitute for a home equity loan. Home values are less volatile — they are not valued daily — and not inclined to drop 40 percent in a day,” says Tracy. 

Nor can a home-equity lender demand repayment because a neighbor’s home sold for less than expected, or sell a home without notice the way a brokerage firm can — and will, with a margin call during a rapidly declining market.

Nancy Condon, an National Association of Securities Dealers spokesperson, is not surprised that sophisticated investors may be using margin accounts for personal financing, but she, too, warns it is not for every investor.

“People did not understand what margin was all about back in 2000," she says. "I’m not sure that has changed.”  For this reason the NASD maintains a number of articles on its Web site to help educate individual investors regarding the risks inherent to using margin regardless of the purpose.

The market rise of 2006 may have increased brokerage account values along with the available credit in those accounts.  But borrowing on margin—whether for investment purposes or to augment spending — is a wealth management tool risk-adverse investors may want to leave buried in the toolbox and one which the less risk-adverse may only want to bring out for special occasions.