The Advantages of a Wealthfront Portfolio Line of Credit Over a Traditional Home Equity Line of Credit
At Wealthfront our mission has been consistent from day one: to provide as many consumers as possible with extremely sophisticated investment management and retirement planning that had once been offered exclusively to the very wealthy.
We tend to ruffle some feathers in the investment community when we execute on our mission and launch new services. Many investment professionals who cater to the wealthy, incorrectly assume we’re trying to steal their clients. So we weren’t surprised to see this community buzzing on social media when we announced Portfolio Line of Credit, saying it was more risky than a common alternative – Home Equity Lines of Credit (HELOC). (Technically Portfolio Line of Credit is offered by our brokerage subsidiary, Wealthfront Brokerage Corporation)
Today, I want to set the record straight.
Let’s be clear, HELOCs do have some advantages, but many of our clients will nonetheless prefer the low-cost and convenience of Portfolio Line of Credit. Let’s look at some of the key questions that arise when comparing the two.
What are the risks?
First, it’s important to understand that there is risk involved with any type of leverage you take on to your personal balance sheet, so you need to understand how to assess those risks. A HELOC is backed by the value of your home and a Portfolio Line of Credit is backed by the value of your portfolio. As such, when negative changes happen to the value of your home or your portfolio, risk can be introduced.
But how much risk? And which is riskier?
It may surprise you, but when looking at a HELOC vs. Portfolio Line of Credit the data shows that the average HELOC can be far riskier than Portfolio Line of Credit. For example, consider a property with a HELOC for which the cumulative Loan-to-Value ratio (value of the primary mortgage and HELOC divided by the value of the home) is 80%. The average borrower in 90% of metropolitan areas, who took out such a line of credit at the peak of the housing bubble, would have been “upside down” when the bubble burst in 2008. A borrower who is upside down owes more on the property than the property is worth — a situation that can have disastrous consequences for their personal finances. Even now, the average borrower in 20% of metropolitan areas would still be underwater despite the recovery in home prices.
In the chart below, we can see that the national average home price just recovered to its pre-crisis levels after peak-to-trough decline of 27% during the crisis. But this is just the average level. San Francisco and Las Vegas are two metropolitan areas where home prices were hit hard between 2007 and 2011. It is impressive how home prices in San Francisco have recovered since and are around 7% higher than their 2006 levels, while Las Vegas home prices are still on average 34% below their pre-crisis levels.
Figure: Home prices during the crisis
Source: Case-Shiller Home Price Indices (Jan 2000 = 100; data are for Metropolitan Statistical Areas)
Now let’s expand on the risk involved in a Portfolio Line of Credit in case you’re unfamiliar. Terminology makes it sound more complex than a HELOC, but it’s relatively simple. An investor will get a dreaded “margin call” when the net equity of her portfolio – the difference between the value of the portfolio and the loan amount – declines below a predetermined level set by her broker. At Wealthfront, a margin call is initiated when your “net equity”, expressed as a fraction of your portfolio value, drops below 30%.
Just as it was common to take on an irresponsible amount of leverage at the height of the housing bubble through a HELOC, many investment firms today allow investors to borrow up to 80% or 90% of their portfolio. If you borrowed 80% of the value of your portfolio, it won’t take a big market downturn to trigger a margin call. In that instance your broker is authorized to sell your securities without even asking you. And because these sales often occur during bear markets, the transactions usually result in the worst possible outcomes for the client.
If this sounds like a precarious situation to put yourself in – it is. At Wealthfront we take our duty to the client seriously and built Portfolio Line of Credit to avoid putting clients in the disastrous situation mentioned.
This is why we only allow you to borrow up to 30% of the value of your portfolio, and we don’t let you use the money to make more investments at Wealthfront. In fact, the value of your Wealthfront portfolio would have to drop by nearly 60% before you become subject to a margin call.
When we look at historical data for our diversified portfolios, we find that clients with even the most aggressive risk level – 10 – who borrowed the full 30% available through Portfolio Line of Credit would not have received a margin call during the 2007 – 2008 financial crisis. Nor would they have received a margin call in 2002 – 2004 during the Dot.com bust. As you can see, we’ve taken great care to keep our clients out of trouble.
Are there differences in addition to risk level?
There are other factors you should consider, in addition to the primary risk addressed above, when evaluating low cost borrowing sources. We’ve put together a handy table to outline the major differences between a HELOC and Portfolio Line of Credit.
How can I use my money from a HELOC vs. a Portfolio Line of Credit?
As we mentioned in the table above, interest on a HELOC may be tax deductible, in which case a HELOC will often offer a lower after tax interest rate. If you use the proceeds from a HELOC loan on home improvements, then all of your interest payments are deductible. If you use them for some other purpose, then only the interest on the first $100,000 borrowed can be deducted. Depending on your financial situation, the tax advantages of a HELOC can be significant. So if you don’t need the money right away, and don’t mind all of the paperwork and hassle associated with the HELOC application process, then a HELOC might be the way to go for you.
However if you have more than $1 million invested with Wealthfront then you will likely qualify for the lowest interest rate, currently 3.25%, which is likely lower even on an after tax basis than many HELOCs. Wealthfront is unique in offering lower interest rates the more you invest. We think this is a much more appropriate incentive than the typical securities backed loan which charges a lower interest rate the more you borrow.
The money you receive from a HELOC or a Portfolio Line of Credit can be used for the same things. You might have a short-term cash need, but don’t want to sell appreciated securities, thereby triggering a tax liability. You might want to buy a car or plan a wedding. You might find yourself facing an emergency medical bill. It’s even appropriate if you need to make a home improvement, but your home hasn’t yet appreciated. One way to think of a Portfolio Line of Credit is a short term bridge.
Another way to use it is the same way businesses use lines of credit — to smooth out cash flow. This is especially true for self-employed people whose income fluctuates during the year or people who earn a large percentage of their annual income in the form of a year-end bonus. They can draw down a line of credit during lean times, replenishing it once their income picks up. There is no limit to the number of times you can access your Wealthfront Portfolio Line of Credit, assuming you don’t go over your 30% balance.
How do I pay off my Portfolio Line of Credit?
One difference between a HELOC and Portfolio Line of Credit is that with the former, you have to make monthly interest payments on your outstanding balance. With Portfolio Line of Credit, all interest payments get added to the principal, which you pay off according to your own schedule. Of course, the interest only accrues on your outstanding balance. So if you borrow $10,000, and then pay back $5,000 the first month, you are only charged interest for the second month on the remaining $5,000 you owe. There is no monthly minimum, so you can pay the Portfolio Line of Credit back entirely on your own schedule.
The Portfolio Line of Credit makes it possible for a much larger group of people to access a low cost way to address short-term financial challenges. We believe that the combination of its low interest rate and ease of access make it superior to HELOCs in all cases other than funding home improvements. However Portfolio Line of Credit is likely also superior to a HELOC for home improvement if your home has not yet appreciated or if you have a significant amount invested with Wealthfront.
Portfolio Line of Credit is a margin lending product offered exclusively to clients of Wealthfront, Inc. by Wealthfront Brokerage Corporation. The risks of margin lending include interest rate risk, margin call risk, and liquidation risk. Read about these risks in the Margin Handbook, and consider them before you borrow.
Nothing in this blog should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront Inc. clients pursuant to a written agreement, which investors are urged to read carefully, that is available at www.wealthfront.com. All securities involve risk and may result in some loss. Wealthfront Inc.’s financial planning services are designed to aid our clients in preparing for their financial futures and allows them to personalize their assumptions for their portfolios. Wealthfront Inc.’s free financial planning guidance is not based on or meant to replace a comprehensive evaluation of a Client’s entire financial plan considering all the Client’s circumstances. For more information please visit www.wealthfront.com or see our Full Disclosure. While the data Wealthfront uses from third parties is believed to be reliable, Wealthfront does not guarantee the accuracy of the information.