There are risks with margin loans. If you borrow up to the limit and your investment value falls, your lender may give you a 'margin call', and ask you to make up the difference in value.
On a normal day, just over 0.1% of the over 190,000 Australians who have a margin loan receive a margin call. On 22 January ('Black Tuesday') one of the large lenders told us about 2% of their clients received a margin call. About half paid back part of their loan and the majority of others had to sell part of their investments. In some cases the lenders sold the investments, as they couldn’t contact the clients.
Faced with the current volatility in the share market, it’s essential for you to try to reduce the likelihood of a margin call and have a strategy in place in case it happens.
How to meet a margin call
A margin loan does not allow you to borrow the full amount, but only a percentage of what you invest the money in, called the investment’s loan to value ratio or LVR. It’s usually 30% to 70% for shares, managed funds and other securities. The LVR determines how much money the lender will loan you against the security.
But if your investment falls in value, you may receive a margin call from your lender. Typically a lender may allow you to exceed the LVR by a percentage such as 5 to 10% before a margin call is triggered.
Once a margin call is made you'll need to top up your investment and also restore the full amount of the buffer.
For example, your lender sets the LVR for an 'Xbank' share at 70%, it’ll lend you $70,000 to buy $100,000 worth of those shares. If the value of these shares now falls by 10% to $90,000 and your lender only allows a 5% buffer margin, they will call you and ask you to make up the difference. At this point you can:
Pay back part of the loan A portfolio worth $100,000 allows you to borrow $70,000 (70%). As your portfolio is now worth only $90,000, you can now only borrow 70% of that, which is $63,000. So you need to pay back $7000 in cash.
Lodge some more shares as security You need to restore the value of your portfolio to $100,000. In a best-case scenario you have some more shares with an LVR of 70% — you need to lodge shares worth $10,000. But if their LVR is only 30%, you have to lodge shares worth $23,333. And if your lender doesn’t have the shares on its approved list you can’t use them at all.
Sell part of your portfolio to pay back into the loan In this case you need to sell about $23,350 worth of shares. This leaves you with an investment worth $66,650 and a loan of $46,650 (about 70% of $66,650).
Stay contactable Make sure your lender can always contact you or another nominated person you trust, even when you’re on holiday or have other commitments. You have to respond quickly to a margin call (usually within 24 hours). If your lender can’t contact you, it’ll make the decision for you.