A margin loan allows you to borrow money, giving you a wider range of investment opportunities and increases your potential returns. It allows investors the opportunity to combine their existing equity with borrowed money to expand their portfolio into shares and managed funds.

The three main forms of security used on a margin loan are:

•    Cash
•    Approved equities: These are ASX listed shares that you already own which the margin lender allows lending against.
•    Approved managed funds: These are managed funds that you already own which the margin lender allows lending against.

Some questions you should ask yourself include:

•    Whether you understand your responsibilities
•    Are you aware of the risk involved in a margin loan?
•    Do you have reserve liquid capital (cash or securities) to meet margin calls at short notice or be prepared that all or part of your securities may be sold down?

 

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Borrowing to invest can multiply your investment returns in a rising market. However, it can also multiply your investment losses if the market declines and your investments perform poorly. This may result in a margin call occurring.

A margin call may be triggered when the margin loan balance exceeds your portfolio lending value by more than the allowed buffer. Margin lenders generally provide a 5% buffer to allow for market fluctuations. As the market value of your portfolio rises and falls, so does its lending value. If the market falls far enough, causing the lending value of your portfolio to fall below your loan balance by more than the buffer, you will be subject to a margin call.

The margin lender understands that investors holding a well diversified portfolio will be better protected if one or more of the investments don’t perform as expected. A diversified portfolio is less likely to trigger a margin call than a non-diversified portfolio. Some margin lenders reward investors who hold a diversified portfolio by granting increased Loan to Value Ratios (LVRs) and access to LVRs on stocks that normally don’t receive a LVR in a non-diversified portfolio. Portfolio LVR may increase the LVR of a security in a diversified portfolio. This increased lending value, can provide investors a larger cover against margin calls or be utilised by investors to further grow their portfolio.

Hypothetical examples of general gearing scenarios

Note: these examples are for illustrative purposes only and do not include interest costs, brokerage, fees or tax.

Joe has $10,000 invested in shares. His colleague Anna also has $10,000 invested in shares and borrows another $10,000 to invest in shares using a margin loan, giving her a total portfolio worth $20,000. Because Anna’s loan represents 50% of the value of the portfolio, Anna has a gearing level of 50%.

The margin lender allows a borrowing limit/ loan to value ratio (LVR) of 70% against the stock. If this ratio is exceeded more than the buffer allowed, a margin call is triggered.

Scenario 1 – value of shares increases by 10%

In this scenario, Joe has made a gain of $1,000 or 10% while Anna has made a gain of $2,000. If Anna were to sell the shares and repay the loan, she would have made a gain of 20% (i.e. the margin loan increased her gains).

Scenario 2 – value of shares drops by 10%

In this scenario, Joe’s loss is $1,000 and Anna’s loss is $2,000. If Anna sold her shares and repaid the loan, she would have made a loss of 20% (i.e. the margin loan magnified her losses). Anna’s loan now represents 55% of the value of her portfolio (i.e. her gearing level is now 55%). No margin call is triggered in this scenario.

This scenario highlights some of the risks of gearing, so it is important to consider the suitability of a margin loan to your objectives, financial situation and needs, which are not taken into account above.

Margin loans may vary in operation. Before considering a particular margin loan, please review the relevant terms and conditions and consult your financial planner or adviser.