A margin loan allows investors to grow their portfolio by borrowing to invest in shares, managed-funds and exchange-traded funds (ETFs). Like a home loan for a property investment, the main aim with margin loans is leverage, which can magnify gains but also magnify losses.
How does a margin loan work?
With the purpose of borrowing funds to invest, a margin loan allows you to leverage your investments in assets which act as loan security. These investments may range from but are not are not limited to, shares, managed funds or even cash.
Loan-to-value ratio (LVR)
Given the nature of margin loans, lenders are likely to restrict the purchase of investments to an approved list of shares and managed funds. This is to ensure you don't put money into a high-risk investment. Typically the lender will require that you meet a particular loan-to-value ratio (LVR). This may vary from asset to asset, depending on the risk involved. The lender may choose to monitor the value of your investments on a daily basis to ensure it remains within the agrees limit - generally up to 80%. In most cases, the larger and more stable the company, the higher the LVR than those considered smaller and more volatile.
If the value of your shares or managed fund dips below the agreed LVR, your lender may expect you to contribute extra funds. This is known as a 'margin call'. If you can't meet this payment, you may be forced to sell your assets at a loss in order to repay your lender.
As with any form of loan, you'll need to make regular repayments. You may choose to pay off both principal and interest, or opt for interest-only. Some lenders also let you choose between a fixed or variable interest rate, and some margin loans even include the option to pay interest in advance. Interest in advance could be beneficial at tax time.
Advantages of a margin loan
- Greater market exposure: Margin lending allows you to acquire more shares or managed funds than you may otherwise been exposed to. This has the potential to help you reach your investment goals sooner, rather than later.
- Greater diversity: Borrowing gives you the chance to spread your investments. By diversifying your portfolio, you can reduce risks.
- Tax benefits: Any interest you pay on a margin loan may be tax deductible. There may also be capital gains tax advantages in borrowing against your existing portfolio to acquire more shares.
- Long-term investment: If you're prepared to make regular contributions to your margin loan, you may end up with a significant asset over time.
Disadvantages of a margin loan
- Market volatility: While margin loans may be of benefit to some investors with additional market exposure and offering the potential for greater returns, it also has the potential to magnify losses. In addition to this, any positive returns need to outperform the cost of borrowing, which can fluctuate with interest rates.
- 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 margin loan lender will ask you to put forth additional funds or another asset to bring the loan back up above the buffer.
- LVR changes: Lenders can adjust their acceptable maximum LVR which can put you at further risk of a margin call.
- Interest rate rises: If you have a variable rate on your margin loan, an interest rate rise will mean there is more interest to pay on your debt.
If margin lending may offer a benefit to your portfolio returns and long-term investment strategy, InfoChoice offers the ability to compare margin lending rates across a number of lenders.