What to consider when choosing a margin loan
Looking to invest? If you want to increase your investment portfolio or start a new investment, you could benefit from a margin loan.
Margin loans are essentially lines of credit that allow you to purchase investments, such as shares and other financial products. Margin loans allow investors to combine their existing equity with borrowed money to expand their portfolio into shares and managed funds.
But before jumping into a margin loan, make sure you are aware of the risks involved.
To be eligible for a margin loan, you’ll need to provide one of the following as security on the loan:
Shares in approved equities: ASX-listed shares that you already own
Approved managed funds:Managed funds that you already own
Margin loan amount
Unlike some other loans such as personal loans, where you can borrow the total amount required to make a purchase, a margin loan works more like a mortgage, where you borrow a percentage of the total value of what you plan to purchase. In a mortgage, it’s buying a property, while in a margin loan, it’s investing in shares and managed funds.
How much you can borrow in a margin loan will depend on the value of investments you’re making and how much security against the new loan you have available. It also depends on the Loan to Value Ratio (LVR) set by the financial institution, which is the amount of money you can borrow compared to the cost of shares or value of managed funds.
All shares and managed funds have different LVRs. Each financial institution will have a list of approved investments with the LVR listed so you can gauge how much you will need to borrow.
For example, if you wished to purchase $10,000 in shares, and the LVR is 80%, you’ll be able to borrow $8000 and provide $2000 as security for the margin loan. The more security you’re able to provide, the more access you will have to borrowed funds.
Margin loan type
There are two different types of margin loans available:
A variable loan is where the interest rate you pay can fluctuate at the lender’s discretion, usually following the nationalcash rate. This means that if the Reserve Bank of Australia (RBA) increases thecash rate, your interest rate may also increase, raising your repayments. If the cash rate decreases, your repayments could get smaller accordingly. This type of loan can be harder to budget for as repayments may not be consistent.
In fixed loans, the interest rate is fixed, so any changes to the cash rate will not affect your interest rate. The advantage of this type of loan is that it is easier to budget your expenses and cash flow, as your repayments will be the same for the term of the loan. With this type of loan, you can choose to fix your rate for a set length of time, usually from two months to five years, however it will depend on the financial institution and what they offer.
Margin loan interest type
With a margin loan, you generally don’t pay down the debt, provided you maintain the agreed level of equity in your account. With this type of loan, you typically only need to pay the interest on the amount of money you use.
The interest can be paid in two ways; in arrears or in advance. Variable margin loans are typically paid in arrears, however fixed margin loans may offer the choice of both. What suits you will depend on the type of loan you choose, but also what you can afford.
Arrears:You pay the interest at the end of each month, for the month just gone.
Advanced:The amount of interest is calculated and you pay the total interest amount upfront in advance. So basically, it is pre-paid. What’s more, the interest you pay on your margin loan may be tax deductible, however check with your accountant or visit the Australian Tax Office for more information.
Margin loan features
There are a range of features that may be offered with margin loans, depending on the financial institution, including:
Options trading:Some lenders offer options trading facilities for when the market outlook is uncertain. Purchase and write options are tools that can help enhance or protect your investments or capital, while covered call options facilities allow investors to enhance returns in falling or flat markets. These tools are usually used by more sophisticated investors.
Mixed collateral:Whether you can choose to use multiple types of security against the loan, such as using property and your shares or existing shares and cash.
Interest in advance:Whether you have the option to pay the total interest amount upfront in advance.
Gearing:Gearing is borrowing funds to invest. Gearing ratios represent the combined ratio of your own funds and borrowed funds for an investment. Be aware however that geared investments tend to have greater risk than non-geared investments.
International shares:Whether the loan offers the option to invest in international shares as well as Australian shares.
Margin loan risks
The return on an investment by using a margin loan can potentially be very significant, but if your investments fail, the loss can be extremely damaging to your financial situation. Whether your investment provides a healthy return or disappears, you are still liable to pay your margin loan debt.
Remember that if you use your home as security for a margin loan, you risk losing your home if your investments fail.
Another risk with margin loans is that you may need to make a ‘margin call’, which is when you need to add to your assets if the value of your investments falls below the maximum loan-to-value-ratio (LVR) on your loan. When your margin loan is higher than the value of your underlying investments, this is called ‘negative gearing’.
Laws came into effect from 1 January 2011 to clarify the responsibility of margin lenders to contact borrowers about margin calls. However, borrowers also need to take some responsibility with their debts, and could be at risk if they’re not contactable.
Margin loans tend to be quite complex, detailed and risky loans, so before you decide to apply for one, you should make sure you fully understand everything about them.
Ask yourself the following questions and if you are not sure of the answers, ask your lender, accountant or financial adviser for more information before taking the leap:
What are the risks involved with taking out a margin loan?
Do you understand how margin loans work?
Are there any tax implications that you can benefit from with margin lending?
What is the risk of negative equity occurring?
Do I actually own my shares? If not, who does?
What happens if the market falls?
Is there any way that I can protect my investment from any fall in the market (losses)?