So I have no plans to ever buy a house or have kids and rent a place with four other people, but I’ve nearly paid off four luxury cars: Lexus LC500, 8-series BMW convertible, Lamborghini Gallardo (bought secondhand), and a BMW Z4 (my commuter car). I’m looking to buy a Porsche 911 next once I hit SDE3 and I really love my cars.
But I basically have no savings and live in the tiniest room in shared house. No school debt. I know I’m in for a rude awakening later in life but what’s the point if you can’t enjoy your youth? Am I making a mistake?
TC: $320ish
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Here is what you do. Let's say that you want to buy a Porsche 992 GT3, and, somehow, get it at MSRP despite all of the shortages. I quickly spec'd one and the MSRP came to $185K. Multiply this value by 5/2. I'll explain why in a moment. Invest that resulting $462K in a portfolio consisting of 90% VOO and 10% BND.
Take out a margin loan from this portfolio for the $185K and use it to purchase your GT3. If you use a broker like Interactive Brokers, then you will have an annual margin loan rate of $1.35%. That's better than you can get from any bank, these days, for a car loan. Bank rates are closer to 2.29%.
Make interest-only payments on your margin loan, which, at the current rates, would be $2.49K annually. Margin loans permit not paying down the principal at a set rate, which is nice. This is because they are backed by your securities.
Hold the margin loan for anywhere from four to six years, unless there's a chance for a margin call. After six years, the value of your portfolio should be around $839K to north of $1.2M. That's assuming a compound annualized growth rate of 10% to 15%, which is possible for the S&P 500 over long time scales. Pay off your margin loan by selling some VOO and BND shares. You'll be left with $654K to $1.01M plus the current value of your GT3 minus the $14.9K you paid in margin interest. Given previous GT3 depreciation rates, it should be worth at least $120K, depending on its condition.
Congratulations, you've likely almost doubled your money during those six years while, essentially, getting a free car in the process. Now you can afford to get anything from a McLaren 720S to an Aston Martin Valhalla using the same process.
Now, as I mentioned above, you want to invest more than the value of the car in stocks. Specifically, you should be investing more than 5/2ths. This magic number is related to margin calls.
When taking out a margin loan, you need to ensure that the value of your assets remains above some maintenance margin threshold. FINRA requires a 25% minimum maintenance margin. Brokerages may require closer to 30%. If you breach this threshold, then you will be subject to a margin call. If you cannot deposit cash to cover that call, then some of your securities will be liquidated so that you are above the maintenance threshold.
If you are not dumb, then margin calls will be rare and, likely, never happen. The key is to not get greedy and, typically, limit yourself to margin loans of less than 40% of your portfolio's value. This is where the 5/2ths ratio comes from, i.e., 100%/40%. If you borrow less than 40%, then the S&P 500 can decline by around 45%, from the time that you entered into the market, before you would be margin called. This is a highly uncommon occurrence. It has happened only six times in over a hundred years. As your portfolio increases in value, the less subject you will be to drawdowns. If you make monthly contributions to your portfolio, then you are further insulated. Eventually, you may be able to resist a 70% market decline without issue. The most the S&P 500 has annually declined has been 57.5%.
@qEno48 You are absolutely correct. I should have covered the corner cases and made the risks clearer. I'll augment what you said below.
If I was severely worried about the margin loan being called, then I'd switch to a more bond-heavy portfolio. Something like 40% BND, 10% TMF, and 50% VOO or 40% BND and 60% VOO would be good choices.
Many brokers let you specify a liquidation plan in the event of a margin call. If that's an option, then I would stipulate that VOO should be sold off, in a min-tax way, before either BND or TMF to satisfy the loan balance. I'd then sell most of the bond ETFs and jump right back into VOO within two months.
The idea behind that is the following. In the event of a major economic downturn, most people flock to bonds. Bond yields drop when they do, which causes their prices to rise. This, in turn, increases the value of the ETFs. For example, in 2020, TMF shot up over 70% the first half of the year. BND was up almost 5%. For 2008, if TMF had existed at that time, then it would have been up by around 50%. BND was up over 6%. In both cases and others, the S&P 500 had declined from its highs, but was recovering, so you would have been well-served getting back into the broader market.
There are two main risks to this strategy, though, as it relates to the margin loan. Bonds are not always inversely correlated with the broader market. They can hence rise and decline in unison. We may see an economic event where both asset classes significantly drop. You could get margin called, especially if your broker is uneasy about the broader economic conditions. Secondly, in the event of a true government default, interest coupon payments would stop being paid. The underlying treasuries in both BND and TMF would quickly be devalued. It's anyone's guess as to what would happen to the M1 supply in that case or even if it would have any remaining value. Margin calls would be flying left and right from every broker.
I should also mention that there are risks involved with jumping back into the broader market after a decline. Depending on what caused it, we could have a lost-decade scenario where the markets trade sideways for a long time. A good example is 2000 to 2010.
If you're concerned about the potential for a margin call, then it's always worthwhile to keep a portion of your portfolio in either cash or VTIP. You miss out on growth, but you're better prepared for a potential margin call. Another option is to simply take out a conventional loan and make monthly payments from your portfolio. Some larger firms will even give you an interest-rate discount depending on the amount of qualifying assets you hold.
Lastly, if you're truly paranoid, then talk to an asset protection lawyer.
Great advice. I've been dipping my toes into margin loans lately. I've been trying to figure out how to structure my risk and this was a simple example to follow.