A margin loan allows you to borrow money to invest in shares, managed funds, exchange-traded funds (ETFs), and other approved financial products. Like a home loan for a property investment, the main aim of margin loans is to increase exposure leverage, which can magnify gains but also magnify losses.
How does a margin loan work?
With margin loans, you use your existing investments (shares, ETFs, managed funds) as collateral, and the lender provides a loan to buy additional investments. It's widely offered in Australia and other developed financial markets such as Canada, Japan, Singapore, the United States, and the United Kingdom.
A margin loan effectively increases your buying power. If you have $20,000 and borrow $20,000, you can invest $40,000. Note, however, that each approved security has a maximum percentage of its value you can borrow against, which is often between 30% and 75%.
Here are a few other things to get yourself acquainted with to understand how margin loans work fully:
Loan-to-value ratio (LVR)
Lenders use LVR as a risk control measure, setting the limits of how much you can borrow based on how volatile or stable the asset is. Typically, the lender will require a particular loan-to-value ratio, which may vary from asset to asset depending on the risk involved.
Higher LVR = you can borrow more against the asset (as it is seen as lower risk)
Lower LVR = you can borrow less (asset is seen as riskier)
Given the nature of margin loans, lenders are likely to restrict the purchase of investments to an approved list of shares or managed funds (e.g. ASX-listed securities). This is to ensure you don't put money into a high-risk investment. In most cases, the larger and more stable the company, the higher the LVR than those considered smaller and more volatile.
The lender may monitor the value of your investments daily to ensure it remains within the agreed limit, which brings us to the next point.
Margin call
If the value of your shares or managed fund dips below the agreed LVR (e.g. 70%), meaning your equity shrinks while the loan stays the same, your lender will issue a margin call.
A margin call is a request from your lender to reduce your LVR by topping up with cash into the loan, adding more shares or managed funds acceptable as security, or selling some of your investments (typically at a loss) to reduce the loan balance.
Here's how it works:
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Say you invest $40,000, $20,000 of your own money + $20,000 borrowed from a margin loan with a maximum LVR of 70%.
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Your portfolio drops to $25,000, thus your equity is now only $5,000 ($25,000 - $20,000 loan).
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$20,000 (loan) / $25,000 (equity) = 80% LVR, which is above the 70% limit.
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At this point, your lender issues a margin call, and you must act.
If you receive a margin call, you usually have around 24 hours to rectify the situation. If you don't act in time, the lender may sell your assets to bring your loan back within the acceptable LVR.
In this scenario, it's possible you lose more than you initially tipped in, which is the inherent risk of margin lending.
Repayments
Margin loans are typically interest-only, meaning you don't pay down the principal unless you choose to. The outstanding loan may continue indefinitely, provided you keep the portfolio's value and loan balance in compliance with the lender's margin or LVR rules.
However, some margin loans might allow or require principal repayments, depending on the lender's terms or jurisdiction.
Pros of margin loans
Leverage
The biggest advantage, and generally the major reason, for taking out a margin loan is the increased investment power. By borrowing against your portfolio, you can take larger positions in the market - beyond the limits of your own cash.
Potential for higher returns
If your investments rise in value, the gains on borrowed funds magnify your total return. This accelerates wealth-building if markets rise because of your greater exposure. To illustrate, a 10% rise on a $40,000 portfolio (half borrowed) gives you $4,000 profit before taxes, instead of $2,000 with no loan.
Diversification
Margin loans allow you to spread across more sectors or asset classes. So if one stock underperforms, your broader portfolio may offset the losses. This can reduce risk while still benefiting from leverage.
Tax benefits
Margin loans can provide tax efficiency for investors, though this depends on local rules. In Australia, any interest you pay on a margin loan may be tax-deductible, as long as the borrowed money is used for an income-producing purpose.
There may also be capital gains tax advantages in borrowing against your existing portfolio to acquire more shares. Not selling existing investments to raise cash prevents triggering a CGT event.
Flexibility
Since margin loans are generally structured to be interest-only and without fixed terms, you can repay when it suits you and keep it open as long as you meet LVR requirements and other applicable service interests. This flexibility makes margin loans a versatile tool for managing an investment portfolio.
Cons of margin loans
Amplified losses
Leverage works both ways - while it can magnify gains, it equally magnifies losses. Going back to the $40,000 invested amount (half of which is borrowed) abovementioned: if your portfolio falls from $40,000 to $36,000, that's a 20% loss on your money ($20,000) even though the market only fell 10%.
This means you can lose money at twice or more the rate of the market. In severe downturns, your equity can even be wiped out completely.
Margin call
If your outstanding loan balance surpasses the borrowing limit by more than the buffer, a margin call can arise. In this case, your lender will ask you to put forth additional funds or sell your assets to bring the loan back up above the buffer.
You may only have around 24 hours to respond, and failure to do so may lead to your holdings being liquidated by the lender without your consent. As such, you need to be prepared and have emergency funds to inject when a margin call happens. Some lenders may have a buffer above the base LVR before a formal call is triggered.
Interest costs
Borrowed money isn't free; you must pay interest regardless of how your investments perform. If your portfolio grows slower than the interest rate - say, 6% growth vs 9% interest - you're going backwards. Unlike equity losses, interest is a guaranteed outgoing.
Volatility and stress
The stock market is inherently volatile, and leverage makes every movement more dramatic. Meaning, even a 2% drop in the market can push your LVR close to danger territory. You need both emotional resilience and ready liquidity to survive the volatility without panicking or being forced into bad decisions.
Is a margin loan right for you?
Margin loans are a double-edged sword. They can be a useful tool, but a tool that needs experience to be handled.
Margin loans magnify exposure, which can translate to greater profit potential but also a faster path to steep losses and stress. LVR rules and the constant risk of margin calls make them unsuitable for most investors.
That said, margin loans are generally suited to experienced investors with a higher risk tolerance, a strong buffer, and a clear strategy. They are not usually recommended for beginners or those who may struggle to meet a margin call.
If you're in need of extra funds, here are some personal loans available on the market. Before you take out any loans, crunch the numbers carefully to make sure it's the right move for you.
