Margin Loans Guide
Looking to invest? You have come to the right place. If you want to increase your investment portfolio or start a new investment, you could benefit from a margin loan. Margin loans are essentially a line of credit that allows you to purchase investments, such as shares and other financial products.
Margin Loans allow investors the opportunity 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.
In order to be eligible for a margin loan, you will need to have one of the following as security on the loan:
- Shares in approved equities: These are ASX-listed shares that you already own
- Approved managed funds: These are managed funds that you already own.
What to consider when choosing a margin loan
1. The loan amount
Unlike some other loans such as personal loans where you can borrow the total amount required, a margin loan works more like a mortgage where you can’t borrow the full amount, but a percentage of the money that you wish to invest in shares and managed funds.
How much you can borrow is dependent on the value of investments and how much security you have against the new loan. It also depends on the loan-to-value-ratio (LVR) set by the financial institution, as all shares and managed funds have different LVRs, which is the amount of money you can borrow as a percentage of the cost of shares or value of managed funds.
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 the LVR for the shares you want to purchase is 80 percent (say $8,000), you will need to fund the remaining 20 percent ($2,000) to borrow the 80 percent. The more security you have, the more access you will have to borrow funds.
2. Loan type
There are two different types of margin loans available:
- Variable loan: A variable loan is where the interest rate can fluctuate to the lenders discretion, usually following the cash rate. This means that if the Reserve Bank of Australia increases the cash rate, so may your interest rate which could result in you paying more in interest. If the cash rate decreases, so might your interest rate and your repayments. This type of loan is harder to budget for as repayments may not be consistent.
- Fixed loan: With this type of loan the interest rate is fixed and 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 fixed term of the loan. With this type of loan you can choose to fix your investment usually from two months to five years, however it will depend on the financial institution and what they offer.
3. 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 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 with fixed you have the choice of both. What suits you will depend on obviously the type of loan you choose but also what you can afford. Definitions of both types are below:
- 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 is that 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.
4. Product features
There are a range of features that may be offered with margin loans, depending on the financial institution. Some of the more common features are listed below:
- 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, whilst covered call options facilities allow investors to enhance returns in the falling or flat markets. These tools are usually used by more sophisticated investors.
- Mixed collateral: Whether you can choose to use multiple types of securities 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 have a greater risk than non-geared investments.
- International shares: Whether the loan offers the option to invest in international shares as well as Australian shares.
5. Margin loan risks
The return on an investment by using a margin loan can 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.
It is recommended that you don’t use your home as security for a margin loan because the risk that you take is if your investments fall you could lose your home.
The other risk to margin loans is that your lender may not inform you when you need to make a ‘margin call’, which is when you need to add to your assets if the value of your investments falls below than 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’.
New laws that come into effect on January 1, 2011, provide clarity on margin lenders’ responsibilities with contacting borrowers about margin calls. However, borrowers need to take some responsibility with their debts and they could be at risk if they’re not contactable.
Margin loans are quite complex, detailed and risky types of loans, so before you decide to apply for one, you should ensure that you fully understand everything about them. Ask yourself the following questions and if you are not sure of the answers, ask your lender or accountant so you can better understand before you take 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)?
7. Star Ratings
CANSTAR star ratings are a consumer-friendly benchmark that help you compare financial products based on their rates and features. We evaluate literally thousands of products from hundreds of finance institutions. Products offering superior value are awarded five stars.
Only the top 5% to 10% of products scored using the CANSTAR star ratings methodology are awarded the prestigious five star status. As a consumer, this is your guarantee of a high-performance product.
For more information on Star Ratings, check out our Star Ratings page
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