What is Margin Lending and Gearing?
A Margin Loan is a loan specifically set up to lend you money to invest. Typically a Margin Loan is set up to enable you to borrow to invest in shares and managed funds. A Margin Loan provides you with the opportunity to invest more than you could using your own money and increase your potential returns.
Similar to purchasing an investment property where you put down a deposit of 10%-20% and borrowing the rest, Margin Lending allows you to buy shares or managed funds with as little as 20-50% deposit, depending on the funds and shares you intend to hold within your loan. This is known as ‘gearing’ your investment portfolio.
In exchange for lending you money to purchase shares, the margin lender will charge you an interest rate (typically 9-10% pa).
Margin lending – Who is likely to find a Margin loan suitable?
- are looking to invest for the medium to long-term (to ride out short term investment volatility)
- have a relatively high, disposable income
- are willing to bear greater risk for the chance of greater return
- have adequate cash reserves or security to fall back on in the event of a margin call
- have some understanding of stockmarket linked investments
- understand that margin lending and gearing multiplies potential losses as well as potential gains
- are looking to reduce their tax bill
Margin lending – What are the benefits?
Increased Investment Capacity – Margin lending can be used as a simple and flexible option to leverage up/gear up your portfolio, allowing you to increase your overall stockmarket investment with a relatively small of your own money.
Diversification – Having more money to invest means you can spread your portfolio across a variety of shares and managed funds. Losses in one investment can be offset by gains in another. Diversification can reduce the investment risk of your portfolio and make your returns less volatile.
Higher Returns – by borrowing money, there is the potential for increased returns by way of dividends and distributions and through capital growth. Many dividends are fully franked. This means the dividend has been paid with income that has already been taxed at the company tax rate. The dividend carries an imputation credit, which you can use to offset your tax.
Tax Benefits – Interest paid on a margin loan is typically tax deductible and by prepaying the next year’s interest now, you can bring forward the tax deduction into the current year. Investors should obtain professional taxation advice that addresses their individual circumstances before taking out a margin loan.
What are the risks?
Margin lending magnifies the potential for both gains and losses. While borrowing can increase your investment returns, it also increases your exposure to potential losses.
A large or sudden drop in the value of your investments can bring the Loan to Value Ratio (LVR) to a level above the agreed limit, resulting in a Margin Call.
What is a Margin Call?
A Margin Call occurs when the overall borrowing is greater than agreed and the lender is looking to restore this buffer zone.
Margin lenders want to be sure that the value of an investment portfolio more than covers the amount borrowed to finance it. This is to protect both you and them:
- It ensures that you don’t lose everything you have invested
- It also ensures that the value of your portfolio covers the debt owed on the margin loan and that you don’t end up owing more than you borrowed
When the value of your portfolio drops too close to the value of your loan, the lender may step in and make a ‘margin call’ and request that you restore the ‘buffer zone’ by :
- Using your own funds to reduce your loan
- Adding further security such as buying more shares to raise the portfolio’s value
- Selling some of the existing portfolio to raise cash to lower the loan amount
How can the risks be minimised?
There are a number of ways to minimise the likelihood of a margin call:
- Don’t use all your available funds ie gear yourself to 50% not to the maximum (typically 70%-80%).
- Diversify your investments across a number of sectors such as industrials, banks, telecommunication etc. By diversifying your portfolio you reduce the risk of falls in one particular sector.
- Stick to your original strategy and evaluate your portfolio regularly. Many investors get caught up in the latest “gold rush” for a particular sector and get caught out when the tide turns.
Remember the responsibility for the management of your portfolio ultimately rests with you. It’s up to you to keep you margin loan account in order at all times. Whilst lenders try their best to contact you if needed, the final responsibility remains with you.