Honestly, it all depends on your situation. For some people it works well and others it can bring on unwanted risk. For purposes of this article we will outline some of the issues you will need to consider for your decision making process. Please know, each person’s situation is different and therefore, it is best to consult with a divorce finance expert in detail about your situation before taking on such risks. What appears to be a safe decision on the surface may not be when you apply a divorce lens to the variables you need to manage.
It is important to understand the fundamental concepts of a margin loan before we address the question around using a margin loan to fund a divorce. Below we describe what a margin loan is, the importance of “maintenance margin”, the types of upside and downside risks you may encounter and how a margin loan could impact the outcomes of a divorce.
What is a margin loan?
A margin loan is a loan an investor receives from an investment firm where the “equity” in the investment account (i.e. the value of the investment account less the value of the margin loan) is used as collateral to secure the loan. The investor uses the proceeds from the margin loan to buy certain types of securities (stocks, bonds, options, etc). It is important to note, an investor can only obtain a margin loan from a non-retirement account. In other words, regulations prevent investors from taking out a margin loan against an IRA, 401k, 403(b), etc. Like any other loan a margin loan has an interest component associated to it. The investor is required to pay back interest to the investment firm (the “lender”) based on the then-current, balance outstanding. Naturally, the principal has to be paid back as well. As a result, it is important to obtain an amortization schedule for the loan to understand the terms and conditions. Yet, the amortization schedule is one of the simpler issues you will have to deal with in this situation. Read on to learn more.
A simple way to think about a margin loan is to think of as if it is a bank loan yet it is a bit different. The investment firm does not have other assets, such as a house, to collateralize the loan. The investment firm only has the equity in the margin account (the combination of the value of the investment and the margin loan together) to use as collateral.
You may be familiar with how a bank loan requires certain metrics or thresholds to be maintained for compliance purposes. For a bank loan, banks look at various metrics such as a debt to value ratio, interest coverage ratio, among other metrics. Margin loans are similar but they use a concept called maintenance margin along with other metrics to manage their financial risks. Below I have elaborated more about maintenance margin. After we have outlined these foundational concepts we will discuss how they can impact your divorce process.
What is maintenance margin?
Whenever an investor uses a “margin account” to buy securities the investor must maintain a minimum level of cash and securities in their investment account as collateral for the margin loan. As noted above, the investment firm has no other assets to collateralize. The investment firm does not use your house or other assets to secure the margin loan. In this context, the term collateral (and more specifically the “current collateral available”) is referring to the marketable securities that you have invested with your investment firm, assuming there are not contingencies or restrictions attached to your investments. The investment firm does not have access to an investment account that resides at another financial institution. As a result the investment firm is limited to using the equity in the investment account as its sole collateral.
Is there any upside to taking out a margin loan?
In short, there can be. How? If the value of the investment increases and you are only paying a marginal rate for the margin loan you can make money off of the margin loan. For instance, if you have invested $10,000 which increases in value to say $12,000 the extra $2,000 is money you can make while being obligated to pay back a margin loan. Yet, truth be told, the risks may not outweigh the benefits. Read below to learn about some of the risks associated to a margin loan.
What are the risks of a margin loan?
According to FINRA (the Financial Industry Regulatory Authority), the minimum maintenance margin that needs to be maintained is 25%. Some investment firms may require a maintenance margin upwards of 30 or 40% of the net equity in the margin account. What does this mean in context to how much you need to maintain in your account? For example (using simple numbers), if you have $10,000 of equity available as the collateral in the margin account, then the investment firm may require you maintain $2,500 of maintenance margin in the account at all times regardless whether the value of the investment account declines in value. In other words, as the market fluctuates the value of the investment account fluctuates as well. This fluctuation will impact how much maintenance margin you need to maintain with the investment firm. If you fall below the maintenance margin the investment firm may issue a margin call. A margin call is when the investment firm sends you a notice to replenish the equity in your account. This assumes you have the funds to replenish the account.
In our example, an account that has $10,000 of equity will have a maintenance margin of $2,500 regardless whether the value of the account declines. The flip side is not the same though. If the value of the account increases to say $15,000 then the maintenance margin increases to $3,750 ($3,750 = $15,000 x 25%). This will be your new maintenance margin that has to be maintained. I know you are wondering whether this is the new threshold you will have to maintain? It all depends on the rules imposed by your institution. So, read the fine print carefully to see if you can ever drop back down to the $2,500 level or you will be subject to a margin call if it declines in value.
How do margin loans impact a divorce?
There are different ways a margin loan can impact a divorce. A fundamental question is whether the margin loan already exists or it will be inserted as a new variable into your situation.
For purposes of this article we will focus on two examples where the margin loan is being added to your situation. The two examples are using the margin loan for your spouse’s legal fees as well as financing the settlement with a margin loan.
- Using a margin loan for your spouse’s legal fees in a divorce
If you allow your spouse to take out a margin loan and your name is associated to the investment account, you will have provided your spouse access to your share of the collateral associated to the investment account. You can become financially exposed if the investment account declines in value. If you do not receive any benefit from the margin loan, it would be wise to add the value of the margin loan (as well as other variables) as a tradable component to your marital estate to allocate between you and your spouse.
- Using a margin loan to finance a divorce settlement
If you and your spouse have already agreed how to settle your marital estate, then you have less of a challenge on your hands. Yet, you have to be sure the terms and conditions of your divorce agreement clearly outline what happens in the interim until title is moved from one party to the other. You will also want to be careful that your spouse has sufficient liquidity to provide you the assets or spousal support you need. If your spouse is dependent on the value of the investment account (which she or he is trading on margin) then your settlement structure may be inadvertently placed at risk.
In both of these situations, the details matter. If you have a situation where you need help managing your risks, please contact us. We can help.
About the Author
Larry Smith is a Founding Partner of Divorce Outcomes, a specialized professional services firm that manages all of the financial aspects in a divorce process. Since 2003 he has worked as a trusted financial advisor, financial advocate, divorce architect and technical financial expert; he is not an attorney. He is an alumni of KPMG and Andersen with expertise in technical accounting, forensics, sophisticated taxation, management consulting, risk management, advanced process engineering, business combinations, divorce management, multi-party negotiations, advanced quality analytics and cognitive performance technologies. Since 1986 Larry has been advising individuals and organizations about innovative financial solutions to resolve complex financial challenges that arise in life and in business.
For both personal and business divorces, Larry is considered an expert in divorce strategies, divorce process management, financial divorce architecture, financial risk management, taxation for divorces, financial divorce forensics, advanced divorce analytics, financial divorce negotiations and mediation, business valuations and sophisticated equity structures. He helps clients shape complex financial decisions, manage communication risks and ever-changing negotiating positions to strategically preserve or grow wealth from these types of transactions.
If You Have a Question
If you have a question, feel free to contact me at [email protected] or 617-680-5222. The call is free. I will spend 30–60 minutes with you. I will provide you an honest assessment as to where I think you are positioned in your divorce process or answer any questions you have. I may provide you some guidance, insight or advice that you can take with you as you wish. There is no obligation to move forward. The phone call is designed to ease your fears, provide you some options to pursue and a potential road to run on that can lead you down a path to achieve a successful outcome.
About Divorce Outcomes
Divorce Outcomes is a specialty services firm that helps people both domestically and internationally manage all of the financial decisions that arise in their divorce process. We are not attorneys. We are financial experts who partner with our clients as their personal financial advocates. We help our clients manage their divorce process, uncover hidden financial risks, architect divorce solutions, manage ever-changing negotiating positions, communicate complex financial matters and close the divorce process as soon as possible with a goal to arrive at the best outcomes possible. Throughout the process we evaluate the current state of our clients’ financial lives with an objective to best reposition their future. We do not sell any products. We simply raise issues that are in our clients best interest. Our clients share with us we:
- unfold, analyze and repackage their financial life so they are well positioned after their divorce
- preserve the value of their business or marital estate
- continuously strive to provide a return on our services
- build balanced financial solutions grounded in evidence
- find ways to make our client, and at times both parties, money through the process
- design their divorce to work for them and their family’s life
- provide mental clarity to make decisions
- reduce the total process time from start to close
- minimize the stress and unpleasant memories that can last a lifetime
This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute formal advice or a recommended course of action as every person’s situation is unique and different. The information here is not intended to be, and should not be, relied upon by the recipient to make a decision without professional guidance.