Investing

A margin loan is an example of borrowing to invest. We are all familiar with the concept: we borrow to invest when we take out a mortgage to buy our home. A margin loan applies some of the same principles to the sharemarket.

Just like a mortgage

Here’s how it works. You borrow money, like any other loan. Just as with your mortgage, the lender wants security over that loan. With a mortgage, the lender has security over your house and can repossess it if you stop making payments; with a margin loan, the lender has security over the shares you buy with it, and can reclaim those shares if you get into trouble with your loan.

Why do you borrow to invest? Maybe you don’t have enough money to build a diversified portfolio from scratch. Or, even if you do, perhaps you want to use leverage to make your money go further. The theory is that, through a small amount of your own capital, you can put a lot more money to work and reap the benefit if your investments perform well.

What’s an LVR?

Let’s look at an example of things working out the way you want them to. You have $5000 to invest in shares, and borrow a further $5000. Since you have borrowed half of your total investment outlay, this means you have a loan-to-value ratio (LVR) of 50 per cent. This will become important later when we come to margin calls; an LVR reflects the proportion of your investment that is borrowed, and most lenders these days will not allow you to go over 70 per cent.

You invest your $10,000 and the whole lot goes up 50 per cent over the next three years, meaning your portfolio is worth $15,000. You’ve had to pay interest on your $5000 loan – say, 10 per cent a year, a total of $1500 – but even then if you repay the loan you come out with $8500, a handy gain. While the shares you owned rose 50 per cent, your overall investment rose 70 per cent. That’s the power of leverage.

The margin call ...

But of course, leverage works both ways. The bane of the margin loan is the margin call.

Remember we started out with an LVR of 50 per cent? Well, what if the value of our shares went down instead of up?

Our LVR would increase – by definition – even though we haven’t borrowed any more money. And once it hits a pre-agreed rate with your lender (70 per cent is typical) the lender will want you to bring your LVR down again to a level it is comfortable with.

Short of a sudden rebound in the markets, there are three ways you can do this:

■ sell some of your shares to raise cash;

■ put more money in; or

■ give the lender security over other shares you may hold.

None of these are desirable. If you have to sell, you are probably doing so at the worst time, as the markets have fallen. (It is sometimes possible to secure a margin loan against your house. Don’t.)

... and how to avoid it

The key to margin lending is to put yourself as far as possible from any risk of a margin call. Many suggest your LVR should be between 30 per cent and 50 per cent.

And remember, a margin loan makes sense only if you think you will make more money in sharemarket appreciation than you are going to pay in loan interest. There’s a tax benefit to that interest, which many set great store by, but don’t let that be the main reason for your investment.

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