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Margin Loan General Tips
What is a Margin Loan?
How does a margin loan work?
What is a margin call?
Things to look for in margin lending products
Margin Loan General Tips
- Look for different interest options, such as variable rate, fixed rate and interest in advance on some fixed rate loans
- Choice of managed funds and shares
- Level of borrowing limit, which is shown on Loan to Value Ratios (LVR)
- Buffer levels (higher buffer levels can considerably reduce the probability of a margin call)
- Brokers approved by the facility and their brokerage fees
- Availability of discount online brokers and the link between the lender and the broker
- Availability of online customer support, which allows convenient and user friendly monitoring investor’s portfolio and simulating strategies
What is a Margin Loan?
A margin loan allows you to invest in shares, managed funds, master trusts and wraps more than you could by just using your own funds. For a new investor, it is easy to imagine a margin loan as a mortgage in a sharemarket. It is become an investment strategy which by borrowing to invest, you may increase your return (at the same time increase your risks).Main drawbacks of the product are volatility of the security, which can result in margin calls, and higher interest rates in comparison to home equity loans. There is a view that margin lending could be also suitable for young, income rich, but asset poor individuals that would like to invest however cannot afford property due to high prices.
How does a Margin Loan work?
Below is a summary how margin loan may enhance on your investment returns. John Smith plans to invest in 3000 XYZ shares with his own funds at $10.00. He noticed that by using a margin loan product, he can leveraged up to 70% of market value, thus invest in a total portfolio size of $100,000.
Illustration of your investments with 70% of security market value is geared with margin loan
01-Feb-06 | 01-Mar-06 | 01-Apr-06 | 01-May-06 | 01-Jun-06 | |
Share XYZ | $10.00 | $10.50 | $11.00 | $11.50 | $12.00 |
No of shares | 10000 | 10000 | 10000 | 10000 | 10000 |
Market movement | – | 5.00% | 10.00% | 15.00% | 20.00% |
Market Value | $100,000 | $105,000 | $110,000 | $115,000 | $120,000 |
Your equity | $30,000 | $35,000 | $40,000 | $45,000 | $50,000 |
Loan | $70,000 | $70,000 | $70,000 | $70,000 | $70,000 |
Current LVR | 70% | 67% | 64% | 61% | 58% |
Profit/loss with margin loans | – | $5,000 | $10,000 | $15,000 | $20,000 |
Profit/loss without margin loans | – | $1,500 | $3,000 | $4,500 | $6,000 |
* based on borrowing shares with maximum LVR at 70% and interest cost is not included as part of the calculations
At 1 June 2006, XYZ price closed at $12.00 and with margin loan he had secured an additional profit of $14,000 or 333% more than he would have gained without margin loan.
When a maximum loan to value ratio (LVR) is exceeded, it will trigger a margin call on your margin loan. A margin call will require you to decrease your borrowing level as a results of decrease in your investment market value (thus your LVR increases). Within a short period (between 24-48 hours), margin lenders require you to add repay part of your loan or alternatively sell your securities to repay part of your loan.
Illustration of margin calls on margin loan products
01-Feb-06 | 01-Mar-06 | 01-Apr-06 | 01-May-06 | 01-Jun-06 | |
Share XYZ | $10.00 | $9.50 | $9.00 | $8.50 | $8.00 |
No of shares | 10000 | 10000 | 10000 | 10000 | 10000 |
Market movement | – | -5.00% | -10.00% | -15.00% | -20.00% |
Market Value | $100,000 | $95,000 | $90,000 | $85,000 | $80,000 |
Your equity | $30,000 | $25,000 | $20,000 | $15,000 | $10,000 |
Loan | $70,000 | $70,000 | $70,000 | $70,000 | $70,000 |
Current LVR | 70% | 74% | 78% | 82% | 88% |
Buffer margin | 10% | 10% | 10% | 10% | 10% |
Maximum LVR | 80% | 80% | 80% | 80% | 80% |
Margin Call Amount | $0 | $0 | $0 | $10,500 | $14,000 |
Profit/loss with margin loans | – | -$5,000 | -$10,000 | -$15,000 | -$20,000 |
Profit/loss without margin loans | – | -$1,500 | -$3,000 | -$4,500 | -$6,000 |
* based on using margin loan at shares with maximum LVR of 70% and interest cost is not included in the calculations
A buffer margin is designed to reduce a probability of a margin call as a results of a small fluctuation in security price movements (eg. intra-day price movements).
In order to reduce the probability of a margin call investor should:
- Diversify portfolio in order to reduce volatility
- Pay interests regularly
- Regularly monitor portfolio gearing level and keep away from the maximum allowed gearing ratio
- Have a strategy in place for meeting a margin call.
Things to look for in margin lending products
- Competitive interest rates and payment options
- A wide range of acceptable securities (Australian shares, managed funds, international shares and also instalment warrants)
- Flexibility on whether you can use the stock broker of your choice
- Regular gearing is a feature of a margin loan which allows you to borrow at a low level that combines with scheduled monthly savings, borrowing and investing into managed funds. It can be a good start for a new investor who look forward to start gearing their investments.
- For sophisticated investors, abilities to purchase and write options are tools that may help them to enhance or protect their investments. A number of lenders offer options trading facilities that are popular when the market outlook is uncertain. Covered call options facilities allowed investors to enhance returns in the falling or flat markets, whilst put option facilities assisted in capital protection.
Disclaimer
This article is over two years old, last updated on September 19, 2006. While RateCity makes best efforts to update every important article regularly, the information in this piece may not be as relevant as it once was. Alternatively, please consider checking recent margin loans articles.
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