Smart Investor: Getting Started, June 2011

Getting Started, Smart Investor, June 2011

A margin loan is an example of borrowing to invest. All of us are familiar with this concept: we borrow to invest when we get a mortgage to buy our home. A margin loan applies some of the same principles to the share market.

Here’s how it works. You borrow money, like any other loan. And, just as with your mortgage, the lender wants some security over that loan. So, 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? Well, maybe you don’t have enough money to build a diversified portfolio of shared investments from scratch. Or, even if you do, you want to use leverage to make your money go further. The theory of this approach is that through a small amount of your own capital, you put a lot more money to work, and reap the benefits if your investments perform well.

Let’s look at an example of things working out the way you want them to. You have $5,000 to invest in shares, and borrow a further $5,000. Since you have borrowed half of your total investment outlay, this means you have a loan to value ratio (LVR) of 50%. This will become important later when we come to margin calls: a loan to value ratio reflects the proportion of your investment that is borrowed, and most lenders these days will not allow you to go over 70%.

Anyway, you invest your $10,000, and the whole lot goes up by 50% over the next three years, meaning your portfolio is worth $15,000. You’ve had to pay interest on your $5000 loan – let’s say 10% a year, for a total of $1500 – but even then, if you repay the loan, you’ve come out with $8,500, for a very handy gain. While the shares you owned went up by 50%, your overall investment has gone up 70%. That’s the power of leverage.

But, of course, leverage works both ways.

The bane of the margin loan is the margin call. Remember that we started out with a loan to value ratio of 50%? Well, what if the value of our shares went down instead of up? As the example in the box shows, our loan to value ratio 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% is typical – the lender will want you to bring your loan to value ratio down again to a level they are 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 some other shares you may hold. None are really desirable, and in particular, if you have to sell you are likely doing so at the worst possible time as the markets have fallen. (It is sometimes possible to secure a margin loan against your house. Don’t.)

Consequently, the key to successful margin lending is to put yourself as far as possible from any risk of a margin call happening. Many suggest your LVR should be between 30 and 50%. And remember a margin loan only makes sense if you think you will make more money in share market appreciation than you are going to pay in loan interest. There’s a tax benefit to that interest, which many people set great store by, but don’t let that be the main reason for your investment.

BOX: Anatomy of a margin call.

Just like the example in the main text, you have $5000 and borrow $5000 for a LVR of 50%. Your agreement with your lender is that your LVR should never go over 70%.

Unfortunately, the value of your shares falls by 30%. This means that the total value of your portfolio is now $7000, and your loan to value ratio – $5000 loan compared to $7000 portfolio – has crossed 70% (71.4% to be precise).

Your lender imposes a margin call. What can you do? If you sold everything now to discharge the loan, your original $5000 would have turned into $2000, minus whatever you paid in interest along the way. Although the market has fallen just 30%, you are actually down more than 60%. That’s leverage the hard way.

You could sell just some of your shares to keep the lender at bay, or you could try to find more cash. But either way you are well down. With time on your side you can ride out the market and hopefully recover, but remember you’ll be paying interest throughout.

BOX: ASIC says…

1. Borrow conservatively.
2. Diversify your investments.
3. Pay your interest on your loan to keep the debt under control.
4. Check your LVR regularly.
5. Have cash ready for margin calls.
6. Shop around for the best loan.