What is a margin loan and how do they work?
When buying property as an investment, the vast majority of Australians will need some form of financing to secure their purchase – but what about taking out a loan for other investments?
A margin loan allows you to borrow money to invest in stocks, managed funds, and exchange-traded funds.
How does a margin loan work?
With the purpose of borrowing funds for investments, a margin loan allows you to leverage your investments in assets, be they stocks, managed funds or even cash, with the assets serving as collateral for the loan.
How much can I borrow?
The Loan to Value Ratio (LVR) is a concept you will often come across when considering a mortgage, but the concept can be applied to other forms of lending. With a margin loan, the amount you can borrow is based on your financial position combined with the value of your existing financial portfolio. This can include a range of items including stocks, managed funds or cash used as a form of collateral. Similar to mortgage loans, the LVR calculation for a margin loan is the amount of your loan divided by the value of the investment (i.e. the funds borrowed plus the existing investments used as collateral).
In margin borrowing, the LVR can be as high as 80% of the security, depending on the size of the company, financial performance, and volatility in the stock price. In most cases, the larger and more stable the company, the higher the LVR than smaller and more volatile companies.
Let’s say you are eligible for a $60,000 margin loan with an LVR of 60%. This means that the lender will allow you to invest up to $100,000 on the condition that 40% ($40,000) of it is your own existing funds.
It’s important to recognize that all forms of investing involve risk, and lending on fractional amounts is no different. On the one hand, borrowing to invest a larger amount of money in stocks or managed funds can offer an opportunity to increase potential returns, but on the other hand, a margin loan can also increase potential losses.
If the portion of your financial portfolio used as collateral decreases due to a stock price decline, you may exceed the maximum LVR required for your margin loan. As a result, a margin call will be triggered and you must:
Reduce your loan amount, or
Add additional security to your portfolio in the form of cash or another asset, or
Sell a portion of your investment until your LVR is below the maximum requirement.
Pros and cons of a margin loan
Alternative to real estate investment: Rather than fighting the crowds to secure an investment property, margin lending lets you borrow a much smaller amount, allowing you to test the investment waters without committing to a mortgage.
Diversify your portfolio: Margin lending can allow you to borrow the funds you need to invest more and potentially diversify your portfolio. Lenders offering margin lending generally do not have a minimum loan amount, which means even investors looking to take advantage of small amounts of money can use margin lending in hopes of taking advantage of their profits.
Liquid investing: Stocks can be turned into cash much faster than investments like real estate. It also means that the margin loan can be repaid more quickly by selling shares, as opposed to a mortgage, which is typically repaid in full after the home is sold.
Tax deduction benefits: Interest on a margin loan may be tax deductible. You can also prepay the interest on a margin loan and possibly include it as a tax deduction during the fiscal year if you prepay the interest.
market volatility: When the market takes a sharp drop, chances are your investment portfolio will too. To avoid taking the brunt of the market downturn, it’s important to diversify your portfolio to lower your risks.
margin call: If your outstanding credit balance exceeds the credit limit by more than the buffer, a margin call may arise. In this case, your margin lender will ask you to provide additional funds or another asset to bring the loan back above the buffer.
LVR Changes: Lenders can adjust their maximum acceptable LVR, which can put you at further risk of a margin call.
Rate hikes: If you have a variable interest rate on your margin loan, a rise in interest rates means you have to pay more interest on your debt.
A margin loan can be an ideal first step into the world of investing, but as with any investment decision you make, it’s important to consider your individual financial circumstances and debt repayment potential before considering the pros and cons Considering the Disadvantages of a Margin Loan. The investing roller coaster can provide an opportunity to grow your financial portfolio, but the volatility of some stocks can actually do the opposite. Talking to a financial advisor can be beneficial to your finances to develop a sufficient borrowing strategy and ensure the risks involved are understood.
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