Margin lending is popular way for educated investors to invest in shares or expand their current share portfolios. Basically, it is a process that involves borrowing money in order to buy shares or other financial products, such as units in managed funds or fixed interest securities. This process is also known as gearing.
Margin lending can potentially lead to higher returns, but it is also considered one of the more risky investment methods and is not suitable for all investors.
Borrowing to invest: margin lending explained
The process of margin lending is similar to that of investing in property; you provide the deposit and a lender will provide the rest. An investor can generally borrow up to 80 percent of the market value of investments.
The obvious benefit of margin lending is that you are able to purchase more shares by borrowing money and can achieve significantly higher returns if your shares rise in price. For example, if person "A" purchases 100 shares at $1 each with their own money and the shares rise to $2 each after a year has passed, they have made a profit of $100. If person "B" borrows money to purchase 1000 of the same company's shares at $1 each, they will have made a profit of $1000 once the shares had risen to $2 each.
The downside to this seemingly marvelous process is that it works the opposite way if the market value of the investment falls. If the shares from the previous example fell to $0.50, person "A" would have lost only $50, while person "B" would have lost $500 and still have to pay off their debt.
Most major financial institutions offer margin loans from an approved list of shares. Australian lenders include ANZ, Macquarie, St George, Commonwealth (or CommSec) and NAB.
LVRs and margin calls
A loan-to-value ratio (LVR) is the amount of money borrowed in relation to the investment value. For example, if an investment is worth $1600 with a loan of $1200, the LVR would be 75 percent.
A margin call is made when the value of an investment falls and the investor cannot maintain the lender's LVR. This means you will either have to contribute more money, sell part of your portfolio or provide the lender with additional security.
It is often the responsibility of the investor to be aware of margin calls. If the investor does not meet the margin call, lenders have the right to sell all or part of their portfolio as they see fit.
Additional risks associated with margin calls
- While the shares you have purchased may rise from $1 each to $5 each over five years, it does not necessarily mean they will not fall in price throughout this time period. Even if the long term outcome is positive, you may have numerous margin calls to attend to throughout the years, which means either putting more cash into your investment or selling part of it.
- Owning shares of various companies will not always protect you from margin calls. If one company's shares are falling in price, it does not always mean that your other shares will be doing well enough to maintain the LVR.
Margin loan suitability
Like any form of investment, margin lending will not suit everyone. Margin lending is generally only recommended to investors with at least one of the following:
- A relatively high income
- An understanding of the stock market and the risks associated with margin lending
- Additional money or security to meet potential margin calls.
Discussing your margin lending options with your stock broker or financial advisor before taking out a margin loan is highly recommended.
