A margin loan allows you to borrow money to invest in shares, managed-funds and exchange-traded funds.
How does a margin loan work?
With the purpose of borrowing funds to invest, a margin loan allows you to leverage your investments in assets, whether those be shares, managed funds or even cash, with the assets acting as the loan security.
How much can I borrow?
Loan to Value Ratio
Loan to value ratio (LVR) is a concept you’ll often come across when considering a mortgage, however the concept can be applied to other forms of lending. With a margin loan, the amount you can borrow is based on your financial position coupled with the value of your existing financial portfolio. This can include a number of items including shares, managed funds or cash to be used as a form of security. Similar to mortgage lending, calculating the LVR for a margin loan is the amount of your loan divided by the value of the investment (which is the borrowed funds plus the existing investments used for security).
For margin lending, LVR may range from anywhere up to 80% of the security depending on the size of the company, financial performance and volatility of the price of shares. In most cases, the larger and more stable the company, the higher the LVR than those considered smaller and more volatile.
Say for example you are eligible for a margin loan of $60,000 with an LVR of 60%. This means the lender will allow you to invest up to $100,000 on the condition that 40% ($40,000) of that is your own existing funds.
It is important to recognise that all forms of investing bear risks, with marginal lending being no different. On one side of the coin borrowing to invest a greater amount of money in shares or managed funds may present the opportunity to increase potential returns, however on the other side a margin loan can also increase potential losses.
If the portion of your financial portfolio used as security drops due to a loss in share price, you may exceed the maximum LVR required for your margin loan. As a result, a margin call is triggered and you will be required to:
Reduce your loan amount, or
Contribute additional security to your portfolio in the form of cash or another asset, or
Sell part of your investment until your LVR is below the maximum requirement.
Pros and cons of a margin loan
Alternative to property investment: Rather than battling the masses to secure an investment property, margin lending lets you borrow a much smaller amount, allowing you to test the investment waters without committing to a mortgage.
Diversify your portfolio: Margin lending can allow you to borrow the funds needed to invest more and potentially diversify your portfolio. Lenders offering margin lending generally have no minimum loan amount, meaning even investors looking to take advantage of small amounts of money can utilise margin loans in the hope of leveraging their gains.
Liquid investing: Shares can be converted to cash a lot quicker than investments such as property. This also means that the margin loan can be repaid faster through selling shares, as opposed to a mortgage which is generally repaid in full after the sale of the house.
Tax deduction benefits: Interest charged on a margin loan may be tax-deductible. You can also pre-pay the interest on a margin loan and may be able to include it as a tax deduction during the financial year when you pre-pay the interest.
Market volatility: If the market sees a sharp decline, it’s likely your investment portfolio will too. To avoid the brunt of market decline it’s important to diversify your portfolio to lower your risks.
Margin call: If your outstanding loan balance surpasses the borrowing limit by more than the buffer, a margin call can arise. In this case your margin loan lender will ask you to put forth additional funds or another asset to bring the loan back up above the buffer.
LVR changes: Lenders can adjust their acceptable maximum LVR which can put you at further risk of a margin call.
Interest rate rises: If you have a variable rate on your margin loan, an interest rate rise will mean there is more interest to pay on your debt.
A margin loan may provide an ideal first-step into the world of investing, however as with any investment decision you make, it’s important to consider your individual financial circumstances and potential to repay debts before taking into account the pros and cons of a margin loan. The rollercoaster of investing may provide the opportunity to increase your financial portfolio, however the volatility of some shares may in fact do the opposite. Speaking with a financial adviser may be beneficial to your finances to form a sufficient borrowing strategy and ensure risks involved are understood.
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