Should you get a margin loan?
I would like to start this blog by explaining that I hate talking about margin loans. Not because there is anything wrong with them but because of the negative connotations attached to the word.
Prior to the GFC, the term “Margin Loan” was a bit of a buzzword. Every scam artist was recommending people get margin loans regardless of their financial situation and subsequently when the GFC happened, a lot of people lost money.
The media jumped straight on the bandwagon of declaring Margin Loans evil and denouncing all those who even consider recommending them. Like all things in finance, margin loans are a tool. When used correctly and for the right reasons, they may be beneficial. However, if you use a margin loan structure without understanding it, you can be in for a whole lot of hurt.
So what is a margin loan? In its simplest form a margin loan is a loan which allows you to borrow to invest and use the investments as security for the loan. It can be a little bit like a residential investment property loan but is used for shares and managed funds. The key thing to note is that whilst borrowing to invest can increase your gains, it can also magnify your losses if things go wrong. This applies equally to residential investment property loans.
Where margin loans start to get a bit tricky is in how they work in practice. To explain I’ll use purchasing shares as an example. When you borrow money to buy shares, the lender takes as security the shares you buy with the loan. This means that the lender can sell the shares to repay the loan.
Now unlike property, shares are priced daily and therefore tend to move in value frequently. This is referred to as volatility. Now if your shares fall in value you may end up in a situation where your shares are worth less than the loan amount. This would be an issue for the lender as they could not recoup their money as the shares are the only guarantee that they have. So to avoid this risk, the lender will use a Loan to Value Ratio (LVR) which they set to gauge the risk of your loan. If your LVR exceeds a set amount (usually a maximum of 70%), then the lender will do what is called a “Margin Call” to restore the LVR.
This complex arrangement is probably best explained by an example. John has $10,000 invested in shares and borrows another $5,000 to invest using a margin loan. This means John has a total share portfolio of $15,000. Because John’s loan is equal to 33% of the value of his portfolio, he has a LVR of 33%. Now assume that John’s margin loan requires him to keep a 49% LVR, this means that John at this rate is fine. However, one day John’s share portfolio falls to $10,000. This means that the loan amount ($5,000) represents 50% of the entire portfolio. As this amount exceeds the LVR, the lender will do a margin call.
In order to meet the margin call, John will have to do one of the following:
- Find extra cash to pay the lender to reduce the loan amount;
- Sell part of the investment to raise cash to reduce the loan amount; or
- Give the lender additional security (e.g. security over other shares).
Prior to the GFC, Australia enjoyed an unprecedented period of growth in equities. At this time, people were making huge amounts of money borrowing as much as they could for investments and were seeing their portfolios grow far in excess of what could have occurred had they just used their own money. The problems arose when the share market inevitably corrected and these people were required to meet margin calls. Having all their cash tied up in investments, they were required to sell their investments and crystalise their losses.
So should you get a margin loan? Like all things in finance, this depends on your particular circumstances and goals. One thing I will say is if you are considering margin loans and are not getting financial advice, you are a crazy person. Margin loans tend to be suited to those who understand them well and have strong cash flow. If you are invested in a way that means that a decline in the market would cause a margin call you cannot afford to pay, you are making a big mistake.
As always please feel free to leave any questions below.
This post is from our resident Financial Planner Cara Brett, check out her details in the About Us section.