What is a margin loan?

A margin loan allows you to borrow money to invest in shares, managed-funds, exchange-traded funds (ETFs), or certain other financial products. While margin loans offer the potential for leveraging and tax benefits, they also present notable risk and can see borrowers losing more than they invest.

What is a margin loan?

An investor can use a margin loan to access more cash to invest than they have available, thereby allowing them to 'leverage', which means to invest with borrowed funds in order to realise larger gains, diversify their portfolio, or access equity without having to sell assets.

However, the 'margin' part represents a significant risk. Those taking out margin loans can be subject to margin calls. 

1. Margin call When a borrower's loan-to-value ratio (LVR) - the difference between the value of the asset used as security and the outstanding loan balance - dips below a set level, their lender can ask them to tip in more cash to rebalance the LVR. This can happen in the event of a market downturn. If the person doesn't (or can't) add more funds to their loan, their lender could begin default proceedings.

How does a margin loan work?

A margin loan uses the investments purchased with its help as security, meaning if you default on a margin loan, your lender could dip into your share portfolio to recover its losses.

They typically work like lines of credit - a borrower might be approved for a set maximum loan size or LVR and withdraw debt up to that limit when and how they want to.

More often than not, borrowers will make interest only repayments for the life of their loan, with the option to repay the debt when they see fit.

Margin loans generally come with significantly higher interest rates than, say, mortgages, largely due to the higher risk they represent to lenders.

That said, most of Australia's major lenders offer margin loans, and some smaller lenders specialise in the products. 

How much can I borrow with a margin loan?

A person's borrowing capacity under a margin loan will depend on their income, financial history, and existing assets to name a few variables.

The latter will likely have a major bearing on their borrowing capacity for a margin loan, as these debt products represent higher risk to lenders, and lenders want to see a borrower can sell assets to help repay the debt if things go wrong.  

A lender will want to know a borrower's LVR - the value of the loan compared to the value of the assets used for security. When it comes to margin lending, the maximum LVR a person can bear may be 80% or lower.

Additionally, a borrower who wants to use a margin loan to buy shares that have historically proven relatively stable might be able to borrow more than one who wants to purchase a high-risk ETF, for instance. 

Benefits of investing with a margin loan

There are plenty of reasons a person might consider taking on a margin loan when investing, including:

• Leveraging
  Like how you might take out a mortgage to invest in property, margin lending lets you borrow funds to purchase other investment assets. If the value of those assets rises, a person who borrowed extra funds in order to invest might realise greater gains than another who only invested their cash savings.

• Diversification
  Taking out a margin loan may allow a person to invest more than they otherwise could across different asset classes or industries, thereby diversify their portfolio and lessening the risk that a single event could cause a portfolio-wide downturn.

• Unlocking equity from assets
  Most investors might think the only way to immediately benefit from their capital gains is to sell their investments, but that's not the case. They might instead take out a margin loan, thereby unlocking their equity as cash without having to sell shares or other assets.

• Tax advantages
  Just like property investors, a person taking out a margin loan can deduct their interest costs from their taxable income. They might even find themselves negatively gearing (though, a negatively geared investor is, by nature, minimising losses rather than realising gains).

Risks of borrowing via a margin loan

This article has already pointed out many risks associated with margin loans, but it will do so again in order to make things perfectly clear:

• Market volatility
  If the market sees a sharp decline, and it likely will, the value of your investment portfolio will probably fall too. If you're borrowing money in order to invest more than you otherwise might, you'll likely realise larger losses if and when the next market correction or crash happens.

• Margin call
  If your outstanding loan balance surpasses the borrowing limit set by your lender, it might enact a margin call. If this happens, the lender can require you to:

  • Deposit more cash
  • Sell some investments
  • Provide extra security

• Interest rate rises
  If you have a variable rate margin loan, an interest rate rise may mean more interest to pay. 

1. If you're considering a margin loan, it's well worth speaking with a financial adviser beforehand. They can help you form a solid borrowing strategy and make sure you're aware of all risks involved.