Margin loan vs cash value loan
I recently began studying life insurance again as I intend to get relicensed for my part-time job as a financial advisor. While I am not a fan of permanent life insurance and annuity products in most situations, as evidenced by my prior musings on this site, the training class I attended pushed the merits of policies that accumulate cash value that individuals can borrow against.
During this class, I asked myself, “Is a margin loan or loan from a permanent life insurance policy more favorable?” If you think that is a nerdy question, it sure is! But if you are intrigued and want to learn the answer, this post is for you!
Before I begin to unpack this question, I must offer the disclaimer that this pensive discussion is entirely educational and meant to ponder the question and its various answers. This blog post is not investment or insurance advice, and it is not prescriptive.
Since investments and insurance are heavily regulated industries, though not enough (in my opinion), I have to clarify this to avoid upsetting regulators or creating potential liability, given my licenses.
Furthermore, everything discussed is a generality regarding brokerage accounts and permanent life insurance since each depends on a provider’s specific offerings. If you have one of these accounts or plans, refer to your provider for specific questions or clarifications.
I also want to be upfront that margin accounts are unsuitable for most investors, just as permanent life insurance is inappropriate for most individuals looking for life insurance. Why? Because margin accounts have specific, highly regulated conditions for borrowing funds and amplify risk substantially. If you fail to maintain adequate investment reserves, you can experience a margin call, which could have undesirable outcomes.
Concerning life insurance, most individuals should consider purchasing a term life insurance policy and investing the excess cash they have because permanent life insurance has a high attrition rate, is not an investment, and carries hefty fees.
Some individuals who are obscenely wealthy or own their businesses could have a use case for permanent insurance. Still, even then, the benefits and drawbacks require evaluation rather than a blanket prescription.
With all these fun disclaimers and opinions aside, let’s dive into the question by unpacking each financial vehicle’s basics, their benefits and drawbacks, and finally, compare them head to head. For those who want to skip ahead to specific sections, I have included a table with clickable links below:
Table of Contents
Understanding marginable brokerage accounts
Margin loans are available for cash withdrawals too
Securities eligible for margin
Benefits of margin accounts and loans
Drawbacks of margin accounts and loans
Understanding life insurance, accrued cash value, and taking a policy loan
Brief tangent about permanent versus term insurance
Benefits of cash value policies and loans
Drawbacks of cash value policies and loans
Comparing margin loans to permanent insurance cash value loans
Why margin loans are better
Why permanent policy loans are better
Analysis & Verdict
When discussing margin, it is helpful to understand what margin is and how it works. To be transparent, understanding this subject takes time, and if you plan to take a margin loan, it is worth studying further, but feel welcome to skip this section if you never plan to take one. So, let’s take a quick crash course into the world of margin accounts!
A margin loan is a way to post collateral in return for a loan which increases your purchasing or spending power. In our modern era, margin loans experience regulation from brokers who issue them, stock exchanges, FINRA (an industry-run, self-regulatory body), the Federal Reserve Board, and the Securities and Exchange Commission (SEC).
The most notable regulatory rule pertaining to margin loans is Regulation T, which determines how much margin/leverage/loan dollars are available to borrowers who post securities as collateral to stock brokers or dealers.
The Federal Reserve Board oversees Regulation T, and the rules state that borrowers can fund 50% of their initial securities purchases using cash, known as the initial margin requirement.
Essentially, Regulation T allows investors to use a margin loan to double their purchasing power for additional securities purchases. For example, if someone wants to buy $20,000 of ABC stock, they only need to deposit $10,000 of cash to their account to make the purchase.
While the Federal Reserve Board governs the initial margin requirement, FINRA and exchanges safeguard broker-dealers against market volatility and credit risk by requiring maintenance margin requirements.
Maintenance margin requirements stipulate that if a customer’s equity in a margin account drops below 25%, they must deposit additional funds as instructed by the broker, which is known as a margin call. Equity, in this case, refers to the customer’s initial purchase value.
Using the example of ABC stock above, if the stock price drops in half and the customer’s total account value is now $10,000, the customer will have an equity balance of 25% remaining (i.e., $5,000) and a borrowed amount worth an equal amount. Notably, the 25% maintenance requirement is a minimum, and a broker-dealer can set the maintenance requirement higher if deemed appropriate for their firm based on the security type or to manage risk.
Suppose a borrower receives a margin call requesting additional funds before a given date but fails to act. In that case, the broker-dealer can sell the customer’s investments without permission to satisfy the margin maintenance requirements (though technically, consent for such actions is mandatory when opening a margin account).
If the proceeds from a forced sale by the broker do not meet the minimum margin requirements due to a dramatic price drop of a given security, the customer will owe the broker-dealer additional funds to keep the account in good standing.
On the other end of the spectrum, if the value of an account with a margin loan rises, the minimum maintenance balance increases, too. For example, if ABC stock price increases and the account above is now worth $30,000, the minimum maintenance requirement increases to $7,500.
Another rule by the Federal Reserve Board, Regulation U, governs margin loans made by banks, credit unions, insurers, and other similar companies. Under this prescriptive rule, lenders can loan up to 50% of an investment’s value for additional securities purchases. Therefore, a $20,000 investment in ABC stock would afford a borrower a line of credit up to $10,000 to purchase more ABC stock.
If a bank-like lender isn’t lending a borrower funds to buy securities, then Regulation U does not apply. Additionally, when margin loans exceed $100,000, the institution must collect a statement of purpose from the borrower.
The primary difference between Regulation T and Regulation U is that the first governs stock brokers and dealers and is used to govern purchases of securities using cash or securities as collateral. In contrast, the latter regulates banks, credit unions, and insurance companies and limits the amount of margin available when using securities as collateral. Notably, Regulation T gives borrowers more purchasing power than Regulation U.
For our discussion, we will focus on brokerage accounts, which are issued by broker-dealers and governed by Regulation T.
For our discussion, it is essential to recognize that some borrowers intend to refrain from using their loans to purchase additional securities. Instead, they will want to borrow cash to spend on things they deem necessary or appropriate.
Under these circumstances, most brokerage firms will allow customers to borrow from their margin account rather than using the available purchasing power to fund additional speculative investment purchases. However, borrowing cash is usually limited to a lesser percentage of account value than when purchasing securities.
When taking a margin loan, borrowers accrue interest, often billed daily through deductions directly from the associated margin account. Therefore, paying attention to the market and the securities held in one’s account is essential to ensure a person meets the minimum maintenance required so that they do not experience an unexpected margin call.
Most stocks, ETFs, mutual funds, US Treasuries, corporate, municipal, and government agency bonds are available for margin loans. However, maintenance requirements and purchasing power may vary depending upon the broker based on the security type. The big caveat is that the security must be readily available and easily traded. If an investment is difficult to exchange, a broker will not extend a margin loan since selling during a margin call could be challenging and places credit risk on the broker.
Notably, only non-retirement brokerage accounts are eligible for genuine margin loans, which excludes IRAs and 401(k)s from being utilized for this type of borrowing.
Margin loans and accounts have various benefits, which include:
- Interest paid on margin loans is tax-deductible when used to buy additional qualifying investments (a qualifying investment produces investment income, i.e., interest and dividends).
- Securities purchased on margin can have favorable tax treatment, such as being eligible for long-term capital gains tax rates, which can be lower than ordinary income tax rates. (To learn more about long-term capital gains eligible investments in my post, How To Be SLI: Asset Allocation Investing)
- Securities are highly portable and can easily be moved between firms once margin loans are closed.
- Most firms do not assess fees for taking a margin loan and only charge interest on the borrowed funds. Furthermore, costs are minimal when trading the underlying marginable investments, and many firms offer no commission and transaction-fee-free options. Additionally, the expense ratios of index funds eligible for margin can be extremely low.
- Marginable securities are almost always highly liquid and can usually be sold within the same day, meaning you can easily access your principal in a crunch.
- Margin accounts are ordinary brokerage accounts, meaning they exist in perpetuity until the account owner dies (or potentially longer, depending on the account registration).
- Investments held on margin or backing margin cash withdrawals remain invested and have the potential to grow.
- Most firms do not require a credit check to open a margin account or take a margin loan.
- In low-interest rate environments, margin loan rates can be meager with certain brokers (such as Interactive Brokers).
- Margin loans do not affect your life insurance proceeds or coverage since they are separate from any policy.
- Most firms allow cash loans without stipulating how the borrower can use the funds.
- Margin loans can be substantial depending on the underlying securities’ value and type. With stock investments being the funds’ targeted use, margin holders can purchase up to 200% of their deposit when investing. For example, a deposit of $10,000 can buy $20,000 of ABC Company stock. Usually, the cash withdrawal option is less than the investment option, though.
- As securities appreciate, the amount available to borrow increases.
- Margin account holders can deduct investment losses up to $3,000 annually. If losses exceed the annual limit, the tax filer can carry the loss forward in future tax years.
- Margin loans increase the potential for investors to increase their earnings when investing since they utilize leverage to amplify their returns.
- Trading with margin without excessive risk-taking is possible but requires using only small amounts of leverage or borrowing only smaller percentages of account value as cash. The reason is that the owner is less likely to experience a margin call or amplify their losses when a margin loan is relatively small compared to the overall account size. However, restraint is required to use margin properly, and it is not for those likely to abuse its perks.
While margin loans and accounts have many benefits, they also have drawbacks, which include:
- Trading with a margin loan to invest in additional securities substantially increases risk and is not a beginner or intermediate investment strategy. Margin loans increase risk when trading because they amplify the potential to make or lose even greater sums of money since the investor has more money to utilize.
- Again, trading with margin is highly risky, and taking a margin cash loan is dangerous when borrowing against potentially volatile securities since the borrower increases their chances of an unexpected margin call. This risk increases when borrowing a larger percentage of the available funds since the account is more likely to hit the maintenance margin requirement.
- Margin loans are callable and can require additional cash infusions at a moment’s notice if the underlying securities drop in value. Further, if a borrower fails to act in time, the broker can sell the investments on the owner’s behalf.
- Margin calls can lead to unfavorable tax consequences when a broker or the client has to sell holdings unexpectedly to meet maintenance requirements.
- Firms often impose minimum margin deposit requirements to open a margin account.
- If a borrower meets the definition of a pattern day trader, they must deposit and keep an account balance of at least $25,000.
- Depending on the broker used a person’s credit score could affect their interest rate for a margin loan.
- Interest rates vary, and while margin loans are inexpensive in low-interest rate periods, they will rise as rates rise, potentially making them expensive and subject to interest rate risk.
- Interest accrues and is often drawn daily, meaning borrowers must have adequate funds to pay charges.
- Investments eligible for margin can drop in value, meaning the amount available to borrow can dramatically decrease in recessionary periods or bear markets.
- Most firms restrict the withdrawal of underlying securities until the margin loan is closed to manage risk.
Now that we have extensively covered what a margin loan is, how it works, and its benefits and drawbacks, it is time to discuss life insurance, cash value, and loans against it.
Life insurance comes in two main flavors, which are temporary and permanent. Temporary life insurance is known as term insurance and lasts for a given term or period. If the insured dies during this period, the policy pays out. Otherwise, the policy expires at the end of the term if the insured outlives it. Because of its structure, term insurance only offers a death benefit for the insured.
With permanent life insurance, both a death benefit and savings component coexist within the policy. When the policy is first established, the death benefit will generally make up the majority of the policy’s value. However, with time, the savings component will accumulate value.
Eventually, the savings component, known as the cash value, will approach the death benefit or eclipse it if the insured lives long enough. The reasoning for this is that the insurance company factors in the insured’s mortality rate to determine how much money is necessary to eventually fund the death benefit, assuming a given growth rate, which can be fixed or tied to external factors depending if the policy is a whole or universal life variant.
During the insured’s lifetime, the insured can borrow against the cash value of their insurance policy, depending on the policy rules. When the insured does this, the policy’s death benefit is reduced by the loan amount since the insurer has lent the owner the money and requires repayment. If the owner repays the loan, the death benefit returns to its prior amount.
However, when a policy owner takes a loan, it will accrue interest. If the owner chooses not to pay the interest charges when billed, they are added to the loan value and begin to accrue interest, too.
While taking a loan from a permanent life insurance policy is commonplace, insurers will regulate loans to ensure adequate funds are available to payout the death benefit and prevent insureds from borrowing more than they have available. If the loan value accrues or reaches the policy’s total cash value, it will deplete the owner’s savings reserves and pose a financial risk to the insurer.
In this situation, the insurer will force the policy to lapse and require repayment or surrender of the policy if the owner cannot return the funds. Policy surrenders can have significant tax consequences, and if you want to learn more about their specifics and outcomes, I suggest reading this article.
Now, out of the two types of life insurance, term insurance is usually the best coverage option for the average individual since it is often substantially less expensive than permanent life insurance, and it breaks out insurance and savings into two distinct and more efficient line items in your budget.
The reason term insurance is less expensive is that most people need and subsequently purchase term insurance when they are young and have yet to accumulate assets to cover their various current and future liabilities. From an insurer’s view, the risk of paying out on a term policy is lower since the insured is younger.
Furthermore, by breaking out insurance needs and savings into separate line items, the policy owner (usually the insured) can focus on their goals more efficiently since they can purchase inexpensive insurance and start saving for retirement using various low-cost investment vehicles, such as an IRA, Roth IRA, 401(k), or brokerage account (which they can, but probably shouldn’t, use margin within).
Most investment accounts in the modern era have no fees and offer inexpensive investment options thanks to the advent and broad acceptance of index funds.
If you want to read further on why I believe term insurance is usually better, you can read my blog post, Why You Probably Need Term Insurance For Protection.
While this digression is not technically relevant to this post’s subject, my reasoning for including it is that many people buy permanent insurance policies that are suitable for them.
But enough with this tangent. Despite the various advantages of term insurance, many people still purchase permanent life insurance, which could be right for them based on their situation.
Assuming a policy owner does not abandon their policy and keeps it in force long enough to build up meaningful cash value, they can borrow against it depending upon their policy rules, which has various benefits and drawbacks that we will now cover.
- Borrowed cash value remains tax-deferred if the policy remains in good standing since it is a loan, not income.
- The entire cash value of a permanent life insurance policy remains tax-deferred until the policy matures, which is usually at age 100 or 120.
- There is no credit check when borrowing against life insurance.
- Policy owners may receive dividends from the insurer if the total premiums the insurer receives exceed their expenses incurred. These dividends are not taxable since they are considered a return of premiums. They are receiveable as cash, can be left to accrue interest, be used to pay policy premiums, or buy additional life insurance. Notably, dividends are not guaranteed year to year.
- Permanent life insurance policies earn interest on all cash value within the plan, including amounts currently loaned out. It is a common misconception that borrowers are repaying themselves when making interest payments. Instead, the money loaned out leaves the insurer’s general cash position while the owner’s policy premium component used to fund the death benefit remains bundled within the insurer’s general investment fund used to pay claims. Therefore, the interest charge paid for policy loans goes to compensate the insurer for what those borrowed monies would have earned so they can fund future payouts.
- Cash value may have partial or complete creditor protection depending on the state the policy owner resides within.
- Interest and loan amounts do not require repayment if the policy remains adequately funded. If the policy owner dies before repayment, the borrowed funds and interest accrued are deducted from the death benefit paid to the set beneficiaries. If the policy owner surrenders the policy and has not repaid the due amounts, they are removed from the surrender value before being paid out.
- Policy loans are generally issued at a lower interest rate than those from banks or brokers. Interest is usually billed annually on the renewal date and can be paid outright or added to the loan value. However, this varies by insurer, and sometimes the interest is billed upfront.
- Some universal insurance policies allow partial surrenders (i.e., withdrawals) to provide policy owners increased flexibility with their monies. Any amount the policy owner withdrawals as a partial surrender decreases the policy’s death benefit by an equivalent amount.
- If the policy owner does not pay the interest charges annually, taking a policy loan increases the risk of causing a policy lapse. This risk occurs because the interest owed compounds with the outstanding loan balance, which eventually can cause the loan value to exceed the available cash value, creating a policy lapse. If the policy owner can repay the required amount, the policy will stay active, and they will retain insurance coverage. If they cannot, the policy and its death benefit will lapse, potentially creating adverse tax consequences and a lack of coverage.
- Insurance loans reduce the death benefit by the outstanding amount plus interest accrued until repaid.
- Whole-life policies have large, fixed recurring payments that often cause people to abandon their policies.
- Universal policies offer variable payment amounts with schedule flexibility but have lower potential cash value to borrow from.
- Permanent life insurance has substantial fees that buyers pay when purchasing a policy, and owners may face additional fees or penalties to borrow against the policy’s cash value. Usually, no cash value exists within the policy for the first couple of years as the insurer recoups their costs to establish the policy. This means there is nothing to borrow against during the initial years.
- Permanent life insurance is a complex product that requires substantial knowledge of policy language and education to understand fully.
- Minimal portability, but policies can be converted to a new one utilizing a 1035 exchange. However, fees and surrenders charges are likely to be incurred.
- Whole life insurance is limited to a growth rate specified within the contract. Universal policies are sometimes tied to a market index or fluctuating interest rate but often have maximum gains allowable before being capped.
- Permanent life insurance is not an investment, and it is illegal to call it as such. Some policies, known as variable permanent life insurance, may have an investment component that utilizes what is known as a separate account where the policyholder can participate in the market. However, these accounts are usually limited to propriety funds with high expense ratios.
- Cash value remains tax-deferred in permanent life insurance policies until maturation, usually at age 100 or 120. Once a policy matures, the face or cash value usually is paid out, and the death benefit and policy cease to exist. If the holder lives until this date, the proceeds that were not premiums, i.e., the interest or gains, are taxable as ordinary income at the time of payment, which is highly unfavorable. Notably, there are riders to safeguard against policy maturity for an added cost.
- Partial surrenders of universal life insurance policies will reduce the death benefit and are taxed as ordinary income once the owner has depleted their balance of premiums paid into the policy. Further, if the owner is under 59.5, the IRS assesses a 10% early withdrawal penalty, and the insurer will likely charge fees for these withdrawals.
- For whole life policy surrenders, the IRS levies the same 10% early withdrawal penalty if a person under the age of 59.5 receives gains and treats all gains as ordinary income.
Alright, we have made it this far into the post, and we are at the moment of truth, are margin or cash value loans better? Let’s compare the aspects of each that are better than the other:
- Life insurance contracts are more complex than trading on a margin. A common personal finance adage is that if you do not understand a financial product, you should avoid it.
- Life insurance is more expensive and has higher fees than margin accounts.
- Margin loans are optional when using a margin account. If one temporarily needs a loan against their securities, they can apply for a margin account and remove the feature when the need is over. With life insurance loans, the policy owner pays more for access to a savings component, making it less efficient.
- Margin accounts cost nothing to open or maintain with most brokers. Permanent life insurance has stipulated payments that must occur for the policy to remain in force. A policy will lapse if a policy owner fails to keep up with monthly or annual scheduled premiums.
- Margin loans come from brokerage accounts containing highly liquid and portable investments. If the account holder needs to liquidate their entire savings, they can once the loan is repaid. Cash value in life insurance policies is less liquid and transportable in comparison.
- Life insurance usually does not have cash value available to borrow against until a couple of years have passed due to the insurance company recovering their costs. Margin accounts are ready to borrow against immediately.
- Margin interest is potentially tax deductible, while insurance loan interest payments are not.
- Unlike permanent life insurance, margin accounts do not potentially mature during the owner’s lifetime. Notably, the policy owner must live exceptionally long for this to occur. (Only 0.02% of Americans live to age 100, and essentially zero live until age 120).
- The relative amount available to take as a loan from permanent policies is less than with margin loans, especially when buying additional securities, which allow borrowers to double their purchasing power. Relative means the dollar amount you can borrow per dollar deposited is more significant with margin than with insurance. Still, both loans will vary based on how much the owner funds them.
- Margin loans can increase by an essentially unlimited amount depending on the underlying securities’ performance. At the same time, cash value has a finite limit to how much it will accrue during an insured’s lifetime.
- Unlike holding a margin account investment, there are no tax consequences for using a cash value loan from a permanent life insurance policy, so long as the insurance policy remains in force. With investments in a margin account, the owner will incur taxes on gains, interest, and dividend payments annually.
- Interest and loan values do not require repayment so long as the life insurance policy remains in good standing. With margin accounts, interest payments must be made regularly (usually daily).
- Cash value loans have no tax consequences for the policy owner if the policy remains in effect. Margin loans occur in taxable brokerage accounts that usually generate taxes.
- Interest rates can be more favorable for policy loans than margin loans. However, this depends on the current interest rate environment.
- Cash value available to take as a loan may have partial or complete creditor protection depending on the state the policy owner resides within. Margin loans occur in taxable brokerage accounts without creditor protection unless registered through certain legal maneuverings.
- Cash value loans can require repayment, but margin accounts can require additional cash infusions on a moment’s notice if the securities backing the loan depreciate dramatically.
- Permanent life insurance is less risky than a margin brokerage account, given the potential volatility the owner faces from asset depreciation.
Suppose someone has a permanent life insurance policy and a brokerage account and wants to purchase additional stock or investments. In that case, a margin loan is likely the better choice, given the superior purchasing power of a margin loan when purchasing stocks.
If someone already has a permanent life insurance policy and margin brokerage account and experiences a short-term liquidity crunch, a cash value loan could make more sense for their cents. This assumes that the cash value option offers a lower interest rate than the margin loan. However, the converse is true if the margin loan provides a lower rate. An example of such a situation would be someone purchasing a new home and selling their old home after they close. When this occurs, the individual may not have access to a down payment or the full closing funds without using margin or a policy loan.
Imagine someone begins weighing how to save for retirement and are considering how to cover potential future income or temporary loan needs. In this situation, the individual should use qualified accounts first and purchase term insurance since it is more efficient. If the individual has additional funds to save, they could place them in a brokerage account and add a margin feature only when needed to cover a potential liquidity crunch. This way, the saver can protect their future income needs using retirement and brokerage accounts, have adequate insurance coverage during the years they haven’t amassed enough assets to cover their premature death, and borrow against their brokerage account when short-term liquidity crunches occur. Choosing a permanent life insurance policy in this situation has a significant opportunity cost and likely attrition.
A whole life insurance policy could make sense if someone is utterly averse to risk when first considering how to save for retirement and wants to draw from it for income. However, it is challenging to recommend wholly since an annuity is likely the better option with adequate term coverage since loans can quickly snowball later in retirement when drawing against a policy for income needs. Further, nearly all people can and should tolerate some level of investment risk, so this is an incredibly uncommon situation.
If a key employee at a firm receives an executive bonus plan funded by the company into a permanent life insurance policy, borrowing against the cash value is a benefit the employer intended for the employee and may be more advantageous than taking a margin loan. These plans are a form of non-qualified deferred compensation, which some companies use to attract talent. The critical determination for employees choosing to take a policy loan is how the company structured the policy with the insurer. Generally, many companies create these as a way to pay employees in a tax-preferrential manner that is not subject to ERISA regulations. If you qualify for such a plan, it is worth discussing the tax implications with an accountant and consulting an independent insurance agent for guidance on whether it is advantageous to defer income into this vehicle for future loans or partial surrenders.
Furthermore, suppose an ordinary life insurance policy owner has an adequate cash value balance to avoid repaying the loan or interest during their lifetime. In that case, a cash value loan is less financially demanding than a margin loan. However, it is essential to remember that the interest charges will accumulate and compound, making it potentially more expensive to one’s heirs, which otherwise would have inherited a greater payout had they repaid the loan.
With the examples above, I have tried to think creatively about how either option could provide a better opportunity for an individual. It is my conclusion, though, that margin loans offer more benefits and fewer drawbacks than cash value loans.
Permanent life insurance loans only make sense for those who have already maintained a cash-value policy or receive one through their employer. Otherwise, these policies have too large of an opportunity cost to consider just for the potential to take a future loan. In most situations, saving in a brokerage account after funding qualified retirement accounts and purchasing a term insurance policy is the best option.
I hope you enjoyed this in-depth analysis of margin and cash value loans. The subjects involved are not easy concepts to grasp, and I hope you will leave your thoughts in the comments below if you have any questions.
If you have experience with margin accounts, permanent life insurance policies, margin loans, or cash value loans, please share them to help others!
Thanks for reading, and as always, have a great day.
Mile High Finance Guy
finance demystified, one mountain at a time