Margin lending is simply borrowing to invest in shares and other financial products using existing investments as security. This is the fundamental difference to a normal investment loan.
How much can I borrow?
Margin lenders allow you to use the value of the shares you are buying (or own already) as security for the margin loan.
Margin lenders specify which shares they are prepared to use for margin lending and the percentage of the share value that can be used as security. You will need to provide cash or other shares to make up the difference between this lending value and the total loan.
The amount that a margin lender is willing to lend is called the Loan-to-Value Ratio (LVR). For example, if a Blue Chip company has a LVR or 70% and you wish to purchase $10,000 worth of shares, they will lend $7,000 (70%) and you will need to provide the balance of $3,000 in case or other shares.
Commonly, the LVR is set at a maximum of 70%, less if the share is more speculative or risky.
This difference between the value of the loan and the current value of your stocks is referred to as the "margin"; hence the term "margin lending". This difference must be maintained at a minimum level.
Should I borrow?
- Margin lending can help you build your wealth over the long term by increasing the size and diversity of your portfolio. Diversifying your portfolio can reduce your level of risk in the market.
- Borrowing also allows you to invest at a time you want to invest, rather than having to wait until you have saved enough. This can help you avoid missing out on investment opportunities.
- Interest on borrowed funds is generally tax deductible provided the funds are invested in Australian assets for income-producing purposes. Deriving a tax benefit should not be your core focus though. You should seek qualified tax advice from a registered tax agent so that you fully understand your personal tax position.
While borrowing to invest can potentially increase your capital return over the long term, it can also prove to be very damaging when conditions change and if employed incorrectly.
- Just as the value of your investment is magnified, your losses can be as well, if the market or value of your shares falls.
- The more you borrow, or leverage, the greater the risk. For this reason you should only borrow up to a level you are comfortable with and leave sufficient buffer in order to maintain the required margin should the value of your shares falls.
- If markets are particularly volatile over a period of time, this devaluation can increase the potential for a margin call (which occurs when the value of your shares falls such that you exceed the specified margin).
Whenever you borrow money to invest you take on a risk that if the investments fall in value you may not be able to repay the loan.
To reduce this risk, margin lenders take security, or a mortgage, over the investments you buy with the loan. If required, these investments can be sold to repay the loan (if you are unable to inject additional cash into the loan).
Unfortunately, as most investors have experienced in recent times, share prices can move down quite quickly, exposing their portfolio to greater risk. If this happens the shares could be worth less than the loan, creating problems for you and a shortfall of security for the lender.
This is the reason why margin lenders limit the amount (LVR) you can borrow for the shares – that is, to protect themselves against this possible shortfall.
If the value of your investments fall to a point where the value of the loan exceeds the maximum LVR you will be required to top up your margin to keep the loan secure.
In the above example, if you borrowed $7,000 to purchase $10,000 in Blue Chip shares, you will have borrowed at the maximum LVR ($7,000/$10,000 or 70%). If the value of the shares falls to $9,000, your LVR would become 77% ($7,000/$9,000) – meaning you have breached your margin limit.
This is known as a "margin call". A margin call will be issued immediately and you will generally only have 24 hours to correct the situation. Your options in this situation are:
- inject additional cash so that the loan balance is restored
- lodge additional investments acceptable to the lender to increase the loan limit
- sell part of your portfolio and use the proceeds to repay part of the loan
If a margin call is not met the margin lending provider can sell the investments, pay out the loan and seek payment of the difference between the proceeds of the sale and the loan from you.
Avoiding margin calls
You can minimise the risk of margin calls by borrowing conservatively – that is, by borrowing less than the maximum LVR allowed by the margin lender.
While there is no guarantee that even conservative borrowers won't experience a margin call, in general your exposure to risk is reduced.
Find out more
You should speak with an adviser before embarking on any borrowing strategy to ensure you understand all the risks involved. Contact us or your local adviser for more information.
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