Margin lending is an investment strategy that lets you borrow money to invest. The assets you buy with the borrowed money are used as security for the loan.
- What is a margin loan?
- Loan to value ratio explained
- Why use a margin loan?
- What are the risks of margin loans?
Most people are familiar with the concept of borrowing money to invest in property and the same concept can apply to shares or managed funds.
Margin lending is an investment strategy that uses one of the oldest financial techniques to enhance your returns – gearing. Gearing means that you borrow money to invest whilst using your own cash or shares as collateral. The theory is that you increase your investment exposure through borrowing, and over time increase your returns.
Unlike property, each asset you hold in a margin loan may have a different lending ratio. For example, you may be able to borrow 75% against a large blue chip stock like BHP but only 40% on a smaller speculative stock. Overall, the assets you hold in your margin loan determine the potential maximum amount of your loan.
One of the more important concepts to understand when you are managing a margin loan is the loan to value ratio or LVR.
The LVR is the amount of your loan divided by the total value of your shares. Each holding in your margin loan may have a different lending ratio itself, but overall, most lenders like you to keep the LVR below a maximum of 70%. As you purchase more with your margin loan the lending value of your portfolio increases so it is important that you take your planned purchase into account when you calculate how much you can borrow.
Careful monitoring of your LVR is an important part of managing risk when using a margin loan as part of your investment strategy.
Margin lending lets you borrow money to invest in shares or managed funds and it is important that you understand both the benefits and the risks involved in margin lending.
If you don't understand how margin lending works then don't take out a margin loan.
If you intend to actively manage your portfolio, consider the benefits of margin lending and keeping your LVR at a conservative level.
The benefits of margin lending can be:
Faster wealth creation - borrowing money to increase the size of your investment portfolio can allow you to grow your wealth at a faster rate and depending on which investments you make, you may have exposure to more dividends.
Diversification - a larger portfolio using borrowed funds can provider greater diversification, lessening the risk that a below average performance in one sector or stock will affect your returns significantly.
Unlocking equity - by borrowing against an existing portfolio, you can invest furtehr without selling your assets and potentially incuring a capital gains tax liability.
Tax effectiveness - depending on your situation, a margin loan may help maximise the after tax return on your investments. For example you may be able to claim the interest on your loan as a tax deduction and received greater dividends with attached franking credits that may reduce your tax liability.
Any investment involves some risk and although a margin loan can be a powerful financial tool that can increase your potential gains it can also increase your risks. The most common risks associated with margin lending are:
- Increased losses if the market falls
- Margin calls as a result of market volatility and/or if your gearing level is too high
- Unexpected changes in the LVR of a particular share or managed fund which can lead to a margin call if the particular investment is a large component of the portfolio
- Increases in borrowing costs if interest rates increase
- Changes to tax laws which may impact the tax position of your margin loan.
You can manage your margin loan to maximise the benefits and manage the risks by: