If you decide you want to make a geared investment in the form of shares or units, you’ll need a margin loan. This is a special kind of debt which allows the borrower to purchase shares or units in a managed fund.
You will need some level of equity though; a margin loan is more like a mortgage than a personal loan in that the lender will only let you borrow up to a certain percentage of the asset value.
How do margin loans work?
A margin loan allows you to buy any shares within the lender’s ‘acceptable securities’ list. This list will vary from one lender to another but most banks and other financial institutions offer several hundred securities to choose from, including shares listed on the Australian Stock Exchange plus quality managed funds.
The exact amount you’ll be allowed to borrow is determined by the lender’s loan-to-valuation ration (LVR) – the amount you can borrow shown as a percentage of the total asset value. The exact LVR will depend on the lender and your choice of security. For example, you may be offered an LVR of 75% if you’re investing in a blue chip company, meaning your deposit would have to be 25% of the value of the underlying security and the lender would supply the remaining 75%. In this case, a $30,000 deposit would buy you $120,000 in shares.
On the other hand, if you’re investing in a less dependable company with a higher element of risk, the LVR may be as low as 40%. In this case, your $30,000 would only get you $50,000 worth of shares as the lender is only prepared to put up 40% of the investment.
How do margin loans increase my return?
Margin loans allow you to invest a relatively small amount of capital but still reap 100% of the returns from the asset – whether in the form of dividends (shares) or distributions (managed funds) – with the added benefit of capital growth over time. As a company shareholder you will have normal voting rights although the security itself is held in trust by the margin lender (this can become important if your investment loses value – more on that below).
In the table below you can see how a margin loan can add significant value to an investment of $50,000.
Assume this investor buys shares which grow by 10% in the first year. The non-geared investor will then have a portfolio worth $55,000 and if we add in a dividend payment of 5% (which we’ll say is reinvested), that becomes $57,750, representing a 15.5% increase on the $50,000 capital invested.
If that same investor used a margin loan with a 50% LVR, the capital growth and dividends are doubled. We must account for the extra cost of loan interest (which could still be tax deductible) so the one-year return for this investor works out at 23.5%.
It’s an even better return for the 75% LVR investor, whose $50,000 investment makes a 39.5% gain in just one year.
Gearing with a margin loan is clearly a good way to make your money work harder for you.
Potential benefits of gearing a shares purchase
|Invest with no gearing||Invest using 50% gearing||Invest using 75% gearing|
|Investor’s own capital||$50 000||$50 000||$50 000|
|Loan value||$0||$50 000||$150 000|
|Value of share portfolio||$50 000||$100 000||$200 000|
|Capital growth (10%)||$5000||$10 000||$20 000|
|Portfolio value||$55 000||$110 000||$220 000|
|Add: Dividends (5%)||$2750||$5500||$11 000|
|Less: Interest cost (7.5%)||$0||$3750||$11 250|
|Equity after 1 year (portfolio value plus dividends less loan and interest charge)||$57 750||$61 750||$69 750|
|Return on invested capital||15.5%||23.5%||39.5%|
The risk of investing with a margin loan
Of course, this kind of investment doesn’t provide a risk-free way to earn annual returns of 40%. There’s a catch – and it’s a big one. The LVR on the underlying security is fixed, meaning it must not exceed this level for the duration of the investment. So if you buy shares with a 50% LVR loan, the shares must hold their value well enough that the loan value never exceeds 50% of the value of the shares.
Due to the volatility of the stock market, there is every chance that price fluctuations may push you over your LVR, and that’s when you can expect to receive the dreaded ‘margin call’.
Simply put, a margin call is a phone call from your lender asking you to take action to get the LVR back to its approved level. You may do this by injecting a lump sum of cash into the loan, by providing additional security, or by selling some of the shares, but you will typically only be given 24 hours to do this. After that tight timeframe has passed, the lender has the right to sell the underlying security – remember a margin lender keeps hold of the security so is in a position to sell without your approval.
Having to arrange any remedial action within 24 hours can prove extremely stressful and may lead to assets being sold for a loss, only to recover their value within a matter of days or weeks (frustratingly for the investor, who has already lost out).
Managing margin loans
The fallout from the GFC saw the amount borrowed through margin loans fall from $37 billion at the end of 2007 to $18 billion by September 2009 – that’s a lot of people deciding their money is better off elsewhere or simply running out of cash to invest full stop.
Again, it’s important not to push yourself to your borrowing limits when an unpredictable asset like shares is involved. If you’re just starting out, aim not to borrow more than 50% of your investment portfolio and have some spare cash to dip into in case you find yourself in a ‘margin call’ situation. It’s easy enough to gradually increase your investment over time as you become more experienced and confident in the market.
The golden rule, as with any investment you are borrowing for, is to buy the best-quality asset you can afford and have a full understanding of how the investment and the loan work. Whether the investment succeeds or fails, you’ll still be expected to cover the loan, and if you’re stuck paying it back from your regular paycheque you could soon find yourself in difficulty.
If you’re at all unsure about gearing, you can always hold off a while until you’ve built up a bigger deposit which will increase your equity percentage and reduce your exposure to the risks involved.
Margin loans in summary:
- Margin loans are designed for borrowers who wish to invest in shares or managed funds
- Your loan-to-value ratio (LVR) dictates how much you can borrow depending on your lender and investment choice
- Margin loans provide a great opportunity to get more from your money but also present added risks in a volatile market
- If starting out, keeping your loan value below 50% of your asset value will offer some protection