Dear Dr. Don,
I have a question about a CD loan. I have a balloon payment coming due on an airplane loan in July 2010. I owe $38,000.
My stock broker, with a well-known reputable firm (Edward Jones), has indicated I can borrow against roughly double the amount (approximately $80,000) of some of my municipal bonds in my portfolio with a margin loan for 6 percent, and have 15 years to pay it off. He said the only real risk is that the interest rate may go up, but probably only in small increments over several quarters.
The lender on the existing loan said it now offers standard 15-year aircraft loans at 8 percent that require a balloon payment in five years. That's the same loan structure as what I have now at 7 percent. He also told me that he could do a margin loan at 3 percent if I deposited $38,000 in a CD with the bank.
I am able to do that, but he told me that I would need to renew the CD every year. He said there are no fees to do so, but the trouble and paperwork every year might be a hassle. He also said he couldn't promise that the bank's position on the conditions of the loan wouldn't change during the life of the loan (red flags!).
I'm thinking of going with the higher percentage loan rate with my Edward Jones dude just because I know he tells me all the facts. He's indicated that while the interest rate might change, the conditions of the loan wouldn't change. What do you think?
-- Subsonic Steve
A CD loan is a loan that has a certificate of deposit as its collateral. This type of loan is typically used by consumers who have poor credit because the bank isn't concerned about credit history in this type of loan -- it has your cash.
To compare apples to apples, you'd have to consider any reduction in yield that came about from investing in the CD as part of the interest expense. If, for example, you cashed in $38,000 of municipal bonds to fund the CD, you'd want to compare the after-tax yield on the CD with the tax-free yield on the municipal bond.
A margin loan is a loan against the value of the securities held in your brokerage account. You typically can borrow up to 50 percent of the value of your portfolio. If your portfolio's value falls, you can face a margin call where you're asked to put up additional capital.
As a borrower, you determine how much you can borrow based on the brokerage firm's initial margin requirement. Margin calls are based on the maintenance margin requirement, which is lower than the initial margin. The interest expense associated with the margin loan is typically a tax-deductible expense, but you'd want to confirm that with your tax professional.
Your broker's rate is competitive with many of its peers, at least according to the April 24, 2010, feature article in Barron's, "Living on the Margin, at a Discount." The article points out how one brokerage firm, Interactive Brokers, is shaking up the street with very low margin loan rates. According to the article, "Interactive Brokers lends at 1.71 percent for margin loans of less than $100,000 and at 1.21 percent for loans of $100,000 to $1 million."
What do I think? I think the CD loan is more expensive than you'd expect. The margin loan will work out just fine if you don't expect any margin calls, and you can deduct the interest expense on your income tax return. Should you change brokers? That I can't say, but you could use your newfound knowledge to try to negotiate a lower margin rate with your Edward Jones dude.
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