What is a margin loan?
A margin loan allows you to borrow money to invest in shares, exchange-traded-funds, and managed funds. It uses your shares that you already have invested as security for the payment of the loan. Your shares that you choose to use as security must be on the lender’s Approved Security List (ASL). These should be similar across each lender, there may however, be small differences as each lender will have their own perspective on the prospects of companies. Borrowing to invest is a medium term strategy that usually lasts for 5-10 years.
Interested about loans? Click here to read up on the difference between a secured and unsecured loan.
How does a margin loan work?
The amount of money for the loan is based on the Loan to Value Ratio (LVR). The LVR is calculated by the amount of the loan divided by the value of your investments (LVR= loan/investment value). Margin lenders require that the LVR is below a certain percentage, normally this is around 70%. Generally, margin lenders will place a small buffer of about 5% because of small daily fluctuations in the market. If your LVR goes above the agreed upon percentage including the buffer, you will receive a margin call, which requires that you lower your ratio back into the agreed limit.
How to lower LVR
If you receive a margin call and wish to lower your LVR you can:
- reduce your margin loan balance by depositing money;
- increase your portfolio value by adding more shares;
- pay off part of your loan balance by selling shares.
If you cant lower you LVR, your margin lender can choose to sell your investments to lower it.
Benefits of margin loans
The main advantage you would get with a margin loan is that you can purchase more shares because you have more money. You might not have had the amount of capital necessary to take advantage of good offers in the market and this type of loan would allow for that. Having more money, means you could diversify your portfolio even further to make sure that you are protected in case one of your stocks plummets. You can also get tax deductions through this type of loan due to the interest payments.
Risks of margin loans
Just as you can make more money through margin loans as you can buy more shares, you also can lose more money if the shares you bought drop. This is concerning when you realise that you also have to pay for the cost of borrowing. You also need to be aware of any potential changes to tax laws as this could seriously affect your investment strategy.
Click here for a case study on someone who opted for a margin loan.
Margin loans are a high risk investment due to the unpredictability of the market and the possibility of great losses. Before taking one out, you should make sure that you fully understand how they work. This guide acts as an introduction to margin loans and is by no means comprehensive. You should seek legal advice if considering a margin loan.
Conclusion
Margin loans are a high risk investment that allows you to borrow money that can be used to purchase shares. The amount has to be within your LVR otherwise a margin call will be issued, forcing you to lower it to the acceptable range. Although margin loans allow you to diversify your portfolio and take advantage of the current market, they additionally come with interest fees and the danger of magnifying losses as more shares are able to be bought. It is up to you to determine whether margin loans are suitable for your situation and your level of risk-aversion. Feel free to reach out to our network of 1000+ lawyers if considering a margin loan.
