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How margin loans work

How margin loans work

In order to grow your wealth, you have to decide what to invest in. Sometimes it’s finding the funds available to invest that causes the biggest headache and why many consider margin loans to kick off their invest portfolios.

You might choose to invest in shares or managed funds, in which case you could use money you’ve saved up. Alternatively, you may borrow money to invest by taking out a margin loan. As with any investment, there are potential benefits and risks.

How does a margin loan work?

If you’ve taken out a home loan, you’ll put down a deposit and then pay off the loan balance over a specified period. Your lender will take a security over your home while you pay off the loan.

In the case of a margin loan, similar principles apply. You’ll borrow a specified amount, and the lender will take a security over the purchased equities or units, explains the Reserve Bank of Australia.

That said, taking out a margin loan is not equivalent to buying your first home.

Are you gearing up for success?

When you borrow to invest, this is known as gearing. 

Gearing is common among property investors who purchase real estate. In the case of taking out a margin loan, you’re also gearing — rather than fronting up the full amount of the investment, you only pay a proportion. 

Given that the share market fluctuates significantly, banks can be hesitant about lending too much money for these kinds of investments. Accordingly, you’ll need to work out your loan-to-value ratio (LVR) if you want to secure a margin loan.

What’s your LVR?

You would have established your LVR when taking out a home loan. You’ll need to do the same when taking out a margin loan. 

This can be calculated by dividing the loan amount by the total share value. When buying a home, LVRs are typically between 80 and 90 per cent. However in the case of margin loans, there are factors beyond your ability to repay the loan — such as share market fluctuations — that result in much lower LVRs.

Minimum LVRs for margin loans differ between lenders. If you want to borrow in order to secure an interest in investment funds, check with your desired lender about LVRs. Be sure to shop around to secure the best possible interest rate for a margin loan, too.

What are the risks?

Finally, you’ll need to school yourself on the risk before diving into margin loan territory.

ANZ notes that “single stock or concentrated exposures” is the single biggest risk faced by customers who secure margin loans. Accordingly, diversified investments are a must.

House prices move up and down, but over the long term, residential properties tend to appreciate in value. On the other hand, share prices move far more often — they could even fall in value.

If your share values drop and your LVR spikes above a pre-determined level, you could receive a margin call. Should you receive such a call, you’ll need to offer extra security or repay a proportion of the loan, often in a very short timeframe.

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