What is a margin loan?
A margin loan allows you to borrow money to invest. The loan is secured against the investment you make with it and/or other investments you have.
You can't borrow the full amount of your investments but just a percentage called the LVR – Loan to Value Ratio. This is usually between 30% and 70% of the value of your investment in shares or managed funds.
The LVR determines how much money the lender will loan you against the security.
Here's the catch
If you borrow up to the limit and then the value of your investment falls you may receive a margin call from your lender and be asked to make up the difference in value. A lender might allow you to exceed the LVR by a percentage of say 5 to 10% before a margin call is triggered.
To make up the difference in value you might have to sell part or all of your investment at a loss. And if this happens at a time when the share market suffers huge losses like in late January 2008, it may be the worst time to sell.
Borrowing money to invest is called gearing. The main tax advantage is that you may get a tax deduction for the interest you pay on your loan and other investment costs - but don't let tax breaks crowd your judgement.
A risky strategy
A margin loan is a high-risk strategy and it's not for everyone. It requires you to be a savvy investor and to get good advice from your adviser or broker to find a good investment.
Is it suitable for me?
Before committing to a margin loan ask yourself the following:
- Do I have enough excess income to cover the interest payments, even if the interest rate suddenly goes up or the investment makes a loss?
- Do I have a long-term investment perspective and the ability to cope with making a loss for some time?
- Do I have a secure job – or the ability to cover the interest payments if I lose my job?
What you need to know
- Make sure you fully understand your loan features and the details of the contract.
- The lender can change the LVR at any time or even take your investments from their approved list – this could trigger a margin call.
- The lender can sell your investments without your go-ahead if you can't meet a margin call, if they can't contact you after a margin call, or if there's a significant fall in the sharemarket.
- How and when will the lender contact you? Lenders can use email, sms and phone.
- Check establishment, transaction and early termination fees that may apply to the loan.
- How does the interest rate compare?
- What's the buffer margin?
- Are all the investments you want to invest in on the lender's approved list?
How do I reduce the risks?
- Reduce your borrowing level: This is the most effective strategy. For example, if the lender allows you to borrow up to 70% of the value of the shares you could just borrow 50% or even only 35%.
- Pay interest regularly: Margin lenders may allow you to add the interest to the loan, but of course this simply increases it and thus your borrowing level.
- Reinvest: Credit your investment income (such as dividends) to your loan, or reinvest it.
- Closely monitor your investments and your borrowing level: This gives you the opportunity to intervene before it comes to the margin call.
- Diversify your portfolio: If you only buy shares in one company your investment will be very volatile. By diversifying your portfolio into shares from different sectors and managed funds, you decrease risk and might have a better return in the long term.
- Get insured: Take out income protection insurance in case you can't work because you're sick. And take out life insurance to cover your dependants if you die.
Top three tips
If you're going to take out a margin loan it's very important for you to try to reduce your likelihood of a margin call, and have a strategy in place in case this happens.
- A margin loan can be a very effective strategy to build your wealth. You need to have excess income, be a savvy investor and happy to take risks.
- Because you have more money to invest, your investment gets a 'turbo boost' and gains are magnified. But if your investment loses money, losses are magnified too and you not only make a loss but you still have to pay back the loan.
- Be aware of the current volatile share market environment, get financial advice and have a strategy in place for meeting a margin call.
How do I meet a margin call?
Take this example:
Your lender sets the LVR for an 'Xbank' share at 70%. They'll lend you $70,000 to buy $100,000 worth of those shares. If the value of these shares 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.
In this case you need to restore the value of your portfolio to $100,000. Here are your options:
- 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: 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 in order to pay back 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, they'll make the decision for you.
Are there any alternatives to a margin loan?
If you've already paid off a big chunk of your mortgage, an equity loan may be a better way for you to borrow to invest. The interest rate is generally cheaper but the same risks apply as with other forms of borrowing, and your house is on the line too.