Protected equity: A safer way to borrow

Protected equity loans enable you to make a geared investment in shares without being liable for any shortfall between the amount borrowed and the value of the shares held as collateral. In short, falling markets don't have to mean losing capital yet you retain the benefits of any increase in the value of the shares and any dividends received during the term of the loan. Higher interest In return for this protection, investors pay a high interest rate. Interest is payable in advance and will depend not only on the term of the loan but also on the shares selected and other market-related factors. At the end of the loan period, if the value of your portfolio has fallen below the amount borrowed you are only required to hand over the shares in settlement of the loan. On the other hand, if the value has risen, you keep the difference between the loan and the portfolio value as well as any dividends received during the loan period. The institutions that provide a protected equity loan and will lend up to 100 per cent of the value of the portfolio and the interest rate will vary accordingly. It is advisable to seek independent advice and make sure that you fully understand the tax and financial ramifications of this type of investment. When considering these protected equity products, investors need to identify the true costs of that protection. For it to pay off, you will need the average returns (dividends and capital growth) across your portfolio to exceed your after-tax loan interest costs. Will the share market rise enough in coming years to cover your interest payments? Protected equity loans are growing in popularity especially for those who want to build up a stake in the sharemarket quickly. They are prepared to borrow a lot to invest given the level of downside protection offered. Tax arrangements There has been much debate about the deductibility of the interest payments on capital protected loans because of the difficulty in distinguishing between the capital protection component and pure loan interest component of the payments. Only the interest component is tax deductible. The Federal Government in 2003 declared an interim tax treatment for protected equity loans but there has been no word on when, or if, a final determination will emerge. The amount of interest available for deduction will be the lower of:

    • the amount determined by the Reserve Bank's Indicator Rate for personal unsecured loans
    • the amount determined on a sliding scale depending on the term of the product (85 per cent for five years, 82.5 per cent for four years, 80 per cent for three years, 72.5 per cent for two years and 60 per cent for one year)

Providers of protected loan products must receive an ATO ruling for each product before these tax rules apply. Go to the Protected equity comparison table.