When making a large purchase, you likely start the process by getting a loan to make the payment. However, loans are not created equal, and knowing the difference between each is the key to making a wise financial decision.

This article will explain what leverage and margin accounts are and the differences between them. Along with that, we will discuss HELOCs and Cash-Out Refinance to give you as much knowledge as possible on the subject at hand. Keep reading to learn more about loans and refinancing, and how to make a choice depending on your needs and current financial situation.

What Is Leverage? 

Leverage is basically an investment strategy in which you use borrowed money to increase the potential return of an investment. It’s a term that can also refer to the amount of debt a firm has that was used to finance assets—for example, when firms use borrowed capital to fund the expansion of their asset base and generate returns. 

Simply put, leverage is the use of debt that allows you to take on an investment or a project. The desired result is for the potential returns to be multiplied. However, leverage also comes with potential risks if the investment does not turn out well. 

Both companies and investors use leverage. Companies use it to finance their assets, meaning that instead of selling stock to raise capital, organizations can use debt to invest in their operations and increase the shareholder value. On the other hand, investors use leverage to improve their returns on investments. They can do so by using various instruments, including futures, options, and margin accounts. 

What Are Margin Accounts?

Margin accounts are brokerage accounts that allow a broker to lend money to a customer so they can purchase stocks or other financial products. This loan is then collateralized by the securities purchased and cash, and it has a periodic interest rate.

Essentially, if an investor purchases a financial product with funds from a margin account and then the product accumulates a higher value than the interest rate charged on the funds, the investor will get a better overall return than if they purchased the product with their own money. This is the key advantage of using margin accounts.

On the other hand, a brokerage firm charges interest on the margin funds for as long as the loan exists. This increases the cost of the financial product for the investor, so if that product declines in value, the investor will have lost money and have to pay interest to the broker.

What’s the Difference Between a Margin Account and Leverage?

Margin accounts are often particularly popular with clients who like to invest in real estate, whether purchasing a rental or hard money lending. This is because, with margin accounts, you can take the funds out on margin and invest them in stocks or have them sent directly to your checking account. Many people think the margin is only good for purchasing equities, but this isn’t the case. 

Margin accounts give clients the necessary liquidity to take advantage of many kinds of investments or access cash. Alpha Wealth Funds’ go-to broker-dealers and custodians at Interactive Brokers (IBKR) have the lowest margin rate around, and we encourage clients to open margin accounts whenever possible because people typically have little time to plan when a real estate investment pops up, a job lets them go, or life throws them a curveball. 

There is no qualification, review period, or required meetings with banks, mortgage lenders, or broker-dealers, making it the fastest way (out of all the below options) to get access to your cash without having to sell out of investments or wait for the bank to review and approve your application.

What Are Home Equity Loans and HELOCs? 

As you probably already know, one of the most significant benefits of being a homeowner is the ability to build equity over time. Then you can use it to secure low-cost funds in the form of a second mortgage, one-time loan, or home equity line of credit. Of course, all of those forms of credit have their distinct advantages and disadvantages, so it’s vital that you understand their pros and cons before deciding to opt for one or the other.

Home Equity Loans 

Home equity loans come as a lump of cash. They’re a great option if you need some money for a considerable one-time expense such as a home renovation or a wedding. Typically, these loans have fixed rates, so you know exactly how much your monthly payments will be when you take one out. Most people know these loans as the original loan they have on their home, and they are sometimes referred to as second mortgages.

With that said, such loans aren’t usually the best solution when you need a small infusion of cash. Even though some lenders will give loans for $10,000, most probably won’t give you one under $35,000. You will also have to pay many of the closing costs that come with a first mortgage, such as recording fees, appraisal fees, loan processing fees, and more. 

HELOCs

Home equity lines of credit (HELOCs) work a bit differently. They are basically a source of funds, similar to a credit card, and you can access them at any time. 

Most banks typically give you a few ways to access those funds through an online transfer, via check, or by using a credit card connected to the account. Unlike home equity loans, HELOCs don’t have closing costs. Usually, they have variable interest rates—even though some lenders offer fixed rates for a specific period of time. 

The flexibility that this credit line offers has its pros and cons. On the one hand, you can get credit at any time, but untapped funds do not charge interest. This is useful if you’re ever in need of an emergency source of funds. 

For example, in times of crisis—like if you’ve lost your job and you need cash but you have equity in your home—taking out a HELOC loan might be a great option. Many banks continue to offer these lines of credit, and they can come in handy when you’re in need. 

What Is a Cash-Out Refinance? 

Cash-out refinance again uses your home’s equity for leverage. It essentially restructures your mortgage to a higher amount to access the difference between your current mortgage and the new one in cash. Simply put, instead of selling your home to access any of the equity you’ve built, getting a cash-out to refinance allows you to get that equity from a lender. 

The money you’ve received can then be used for anything you want and is paid back in the form of a new mortgage payment, which depends on the terms and agreed-on amount. It should be noted that cash-out REFIs have been particularly popular over the past year or two due to the drop in rates, but now that the mortgage rates have gone back over 5%, there may be better options. 

The amount of money you will be able to get depends on your current mortgage amount and the worth of your home. It’s vital to note that you won’t ever be able to cash out the entire difference between the value of your home and balance of your mortgage. Instead, you will be able to receive a certain percentage, in most cases, up to 80% of your home’s loan to value ratio. 

One of the downsides of this process is that you will need to pay closing costs as with a traditional mortgage. Typically, closing costs for a cash-out refinance will range from 2-5% of the new mortgage amount, with the average amount being around $4,000. 

If you want to see a breakdown of the fees involved at closing, ask your lender to provide you with one. Usually, they include loan origination and appraisal fees, among other things.

Differences Between Home Equity Loans and Refinancing

In some cases, refinancing has some advantages over a second mortgage. The interest rate is frequently lower than the one you get with home equity loans, and if overall rates drop, you’ll want your primary mortgage to reflect that.

With that said, refinancing has some drawbacks as well. For example, closing costs tend to be much higher than those associated with HELOCs, usually with low upfront fees. In some cases, you may have to pay private mortgage insurance if you have less than 20% equity in your home. 

Your choice predominantly depends on what you plan to do with the money and what you’re willing to pay, either in fees or monthly payments. 

Key Takeaways 

Having the option and ability to pull out cash when needed is critical. For example, if you lose your job and then try to get a cash-out REFI, you aren’t likely to qualify. It is strongly advised to plan ahead in-depth to prepare for these scenarios and invest in a Financial Advisor that can help you set up safety nets before you need them. 

To provide yourself and your loved ones with the most security possible, you might consider opening a brokerage account as a margin account initially and then getting a HELOC set up when you’re working.

As with all financial decisions, if you’re uncertain of what to do, the best idea is to consult with a specialist, who will take a look and evaluate your financial situation so that you make the best possible choice for your future. Clients at Alpha Wealth Funds receive expert advice from Certified Financial Planners so they can have a better understanding of their finances and a clear path to reaching their goals. Contact us to learn more.

Please feel free to reach out to me on this or any of your investment needs or questions. I may not always have the answers at my fingertips, but I promise I will get them for you. Michael Torrence

Calendly link https://calendly.com/mt-awf/intro Work: 435.658.1934 Contact: 330.284.3211
Michael Torrence – Investment Advisor Representative: Michael was born and raised in Ohio and attended The Ohio State University. After College, he was commissioned as a 2ndLt in the United States Marine Corps. He attended his initial training in Quantico, Virginia, then graduated at the top of his Primary Aviator Class and was selected for the Strike (Jet) Platform.

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