One of the most compelling options a bank can offer its clients is leverage: lending them money to increase their potential return on investments. Leveraged investing can be a part of your financial strategy if you explore it in moderation and use the right tactics.
“You don’t want to be overleveraged in any way, shape, or form, but leverage in moderation can be a really powerful tool,” says David Mook, chief private banking officer for U.S. Bank Private Wealth Management.
In particular, three types of debt can be used for leveraged investing: liquid asset secured financing, estate planning debt, and home debt.
1. Liquid asset secured financing
A liquid asset secured line of credit is like a home equity line of credit (HELOC), except it is secured by your investment portfolio instead of your home. This allows you to access liquidity without the need to sell assets and incur potential capital gains taxes resulting from the sale of the assets.
Liquid asset secured financing may be a good option for you if you need to generate cash flow quickly. It also offers the benefit of lower interest rates, as it’s a lower-risk option.
Other uses for liquid asset secured financing include:
- Funding special purchases
- Paying a tax bill
- Refinancing higher interest rate debt
If you have a higher risk tolerance, Mook says you can also use liquid asset financing to take advantage of interest rate arbitrage opportunities for investments you think will generate a high rate of return. It’s important to keep in mind, however, that if the investments do not generate the expected returns, losses are increased as a result of the use of leverage.
2. Estate planning debt
Contrary to popular belief, debt can facilitate wealth transfer. Two estate planning strategies, in particular, can help: life insurance policies and grantor retained annuity trusts (GRATs).
Add this as another reason to have life insurance: You can use your policy to help pay for estate taxes after your death. Leveraging your life insurance policy allows the estate to distribute assets at a pace that maximizes the estate’s value. Mook notes that insurance can be expensive. “If you don’t want to write a large check every year,” he says, “you can finance that premium and use the cash value of the policy or other assets as collateral for the loan.”
Grantor retained annuity trust
A GRAT is a trust set up for a short time period (usually two to five years) that helps transfer assets in a tax-efficient way.
You place assets into the trust but also maintain the right to receive the original value of the assets in addition to earning a rate of return known as the 7520 rate1, as defined by the IRS. Over the life of the GRAT, the assets will inevitably rise and fall in value.
Bank financing could help protect your gains and shield you from losses by allowing investors to substitute a stable asset for a high-growth one — for instance, substituting cash for stock secures any gains in the stock value to date. If you don’t have the cash to make that substitution, a bank can lend it to you. When the terms for your GRAT are up, the amount of assets above the original value plus interest (at the 7520 rate) is given to your beneficiaries.
3. Home debt
A home is a valuable asset on its own, but you can also leverage its equity. You can use money from either a second mortgage or a home equity line of credit (HELOC) to buy a second home, renovate an existing home, or purchase a commercial property. Doing so can generate income while also diversifying your portfolio.
Home debt is a higher-risk way to borrow, but for those with a high-risk tolerance, the advantages of real estate investments are clear:
- If you believe the real estate will appreciate, you can access liquidity without selling the property and missing out on potential future gains in value
- You may be able to rent out a second property, generating additional income
- Small business owners may be able to use money from a second mortgage to fund their business at a lower rate than what’s available to the business entity
Leveraging different types of debt can be a smart investment strategy if you know which tactics will work best for your financial situation.
“We want to give our clients flexibility,” Mook says. “By helping them use leverage, we can make sure they’re able to take advantage of financial opportunities when they become available.”
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