Margin Lending

Margin Lending – what is it all about?

One simple wealth strategy to assist you on your journey to financial independence is to establish a margin loan.  A margin loan is essentially a loan which enables you to invest borrowed funds in shares or managed funds and therefore potentially achieve higher returns than you would otherwise.

In many ways, a margin loan is not dissimilar to a mortgage. The more security you can provide in the form of cash or equity, the more money you are likely to be able to borrow. The Loan-to-valuation ratio (LVR) will determine how much you can borrow.  The LVR will depend on what particular investments you intend to invest in.  Managed funds and shares have an LVR, which is calculated by the lender based on such variables as liquidity and volatility.  For example, blue chip shares such as BHP may have an LVR of 70%.  What does this mean?  Well, if you had $3,000 in cash and wanted to borrow funds to buy BHP, at an LVR of 70%, the lender would loan you a maximum of $7,000 against your equity.  In this scenario, you would have $10,000 of BHP shares, of which you would own $3,000 and the lender $7,000 (which is where we get the 70% LVR number from).

Now, I know what you are asking . . .why would you want to take out a margin loan to purchase shares or managed funds?  Well, there are different answers for different investors.  It may be that you are particularly bullish on a particular stock and want to increase the exposure to this company.  It may be that you are overweight other shares in your portfolio and would like to diversify within that portfolio without selling existing shares.  Or it may be that, because the interest payable on the loan for the shares is tax deductible, you are able to use the borrowed funds to reduce your taxable income while at the same time getting greater market exposure.  The greatest benefit of margin lending, or burrowing to invest in general, is that when the market or your particular shares move in your favour, the leverage means that you experience much greater growth than without gearing.

So, what are the risks involved with margin lending I hear you ask.  The biggest risk as we have already determined is that although you will benefit when the market moves in your favour, you will suffer greater losses when it moves against you.  This is where a ‘Margin Call’ comes into play. If the value of your shares falls below a certain level, you will be forced to sell some of your portfolio or to find additional funds to reduce the ‘borrowed amount’ and bring your LVR back to within the maximum allowable levels.

Here is an example of margin lending at work, in both positive and negative markets.

Let’s assume, as mentioned above that you have $3,000 and would like to invest in BHP shares.  Your lender verifies that the share has an LVR of 70% so you borrow $7,000 and now you have a BHP holding of $10,000.  Excellent!

Some time later, BHP shares have increased by 10%.  Not bad, now your portfolio is worth $11,000.  So, what if you sold those shares and realised your gain.  Your return on equity is actually much greater than 10%.  Check out this table below to see the comparison between using only your own equity and using your equity plus a margin loan.

	Own Equity Only	Equity + Margin Loan (70% LVR)
Initial Equity	$3,000	$3,000
Borrowings	NIL	$7,000
Total Investment	$3,000	$10,000
Portfolio Increases by 20%
Total Investment	$3,600	$12,000
Net Equity (equity less borrowings)	$3,600	$7,000
Profit	$600	$2,000
Return on Equity	10%	66%
New LVR	N/A	58.3%

As you can see, 66% return as opposed to a 20% return.  This does not take into account fees and interest expense but you can see the potential borrowing provides.  Not only that, your LVR (the % the lender owns compared to the overall portfolio value) has dropped from 70% to 58.3%.

Unfortunately, markets don’t always go up in the short term.  (Over the longer term, it’s a different story).  But, let’s assume that markets go the other way and your investment suffers a 20% loss.  What does that then look like?

	Own Equity Only	Equity + Margin Loan (70% LVR)
Initial Equity	$3,000	$3,000
Borrowings	NIL	$7,000
Total Investment	$3,000	$10,000
Portfolio decreases by 20%
Total Investment	$2,400	$8,000
Net Equity (equity less borrowings)	$2,400	$7,000
Profit / Loss	$600	$1,000
Return on Equity	- 20%	- 66%
New LVR	N/A	87.5%

Not only have we suffered a greater loss of equity, the LVR at 87.5% is now greater than the lender agreed to lend.  This is where a ‘Margin Call’ comes into play. Once you exceed the stated LVR, you will be forced to sell some of your portfolio or to find additional funds to reduce the ‘borrowed amount’ and bring your LVR back to within the maximum allowable levels.

There are strategies such you can use to mitigate a margin call happening such as not borrowing to the maximum LVR or making regular contributions to the loan account or the portfolio.  These are strategies that you need to discuss with you financial adviser.

In summary, Margin loans can be a very handy way to generate stronger returns or diversify your portfolio. There are many options available and most banks offer this facility.  Speak to your financial adviser to see if this simple wealth strategy is right for you.

Happy Investing.

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