What is a margin loan and how do they work?

When buying property as an investment, the vast majority of Australians need some form of finance to secure their purchase – but what about taking out a loan for other investments?

A margin loan lets you borrow money to invest in stocks, managed funds, and exchange-traded funds.

How does a margin loan work?

For the purpose of borrowing funds to invest, a margin loan allows you to leverage your investments in assets, be it stocks, managed funds or even cash, with the assets serving as loan guarantee.

How much can I borrow?

Loan to value ratio

Loan-to-value ratio (LVR) is a concept you will come across often 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 situation coupled with the value of your existing financial portfolio. This can include a number of things including stocks, managed funds or cash to use as a form of collateral. Similar to a mortgage, the LVR calculation for a margin loan is your loan amount divided by the value of the investment (which is borrowed funds plus existing investments used for security).

For margin loans, the LVR can be up to 80% of the security depending on company size, financial performance and stock price volatility. In most cases, the larger and more stable the company, the higher the LVR than those considered smaller and more volatile.

For example, let’s say you qualify 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 provided that 40% ($40,000) of this amount is your own existing funds.

margin call

It is important to recognize that all forms of investing carry risk, marginal lending being no different. On one side of the coin, borrowing to invest a larger sum of money in stocks or managed funds may present the possibility of increasing potential returns, but on the other hand, a margin loan may also increase potential losses.

If the portion of your financial portfolio used as collateral drops due to a decline in the stock price, you could exceed the maximum LVR required for your margin loan. As a result, a margin call is triggered and you will need to:

  • Reduce your loan amount, or

  • Provide additional security to your portfolio in the form of cash or another asset, or

  • Sell ​​some of your investment until your LVR is below the maximum requirement.

Advantages and disadvantages of a margin loan

Advantages

  • Alternative to real estate investment: Rather than battling the masses to secure an investment property, margin lending allows you to borrow a much smaller amount, allowing you to test the investing waters without committing to a mortgage.

  • Diversify your portfolio: Margin lending can allow you to borrow the funds needed to invest more and potentially diversify your portfolio. Lenders offering margin loans generally have no minimum loan amount, which means that even investors looking to leverage small amounts of money can use margin loans in hopes of taking advantage of their earnings.

  • Liquid investment: Stocks can be converted into cash much faster than investments such as real estate. It also means that the margin loan can be paid off faster by selling stocks, unlike a mortgage which is usually paid off in full after the house is sold.

  • Advantages of the tax deduction: Interest charged on a margin loan may be tax deductible. You can also prepay the interest on a margin loan and optionally include it as a tax deduction during the year when you prepay the interest.

The inconvenients

  • Market volatility: If the market goes down sharply, chances are your investment portfolio will too. To avoid the brunt of the market downturn, it’s important to diversify your portfolio to reduce your risk.

  • Margin call: If your loan balance exceeds the borrowing limit by more than the buffer, a margin call may occur. 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 may adjust their maximum acceptable LVR, which may expose you to additional margin call risk.

  • The interest rate increases: If you have a variable rate on your margin loan, an increase in interest rates will mean that there will be more interest to pay on your debt.

Last word

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 personal financial situation and debt repayment potential before to consider the pros and cons of a margin loan. . The roller coaster of investing can provide the opportunity to grow your financial portfolio, but the volatility of certain stocks can actually do the opposite. Talking to a financial adviser can be beneficial for your finances to develop a sufficient borrowing strategy and ensure the risks involved are understood.


Image by PiggyBank via Unsplash

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