Margin lending loses its popularity

Data provided by the Reserve Bank of Australia (RBA) has revealed that margin lending has slumped in popularity despite record low interest rates and a surging market, showing that investors have followed the lead of companies since the global financial crisis (GFC) by decreasing their exposure to debt where possible.

A margin loan is an arrangement whereby investors can take out a loan to buy shares whilst using their existing shares as security. It can provide a boost to one’s portfolio when things go well, but if the value of the shares fall a certain amount, the issuer of the loan, such as Westpac (ASX: WBC) or NAB (ASX: NAB), can sell the stocks to regain the money or otherwise demand more payment.

Prior to the GFC, there was a very high level of margin lending in the economy as investors aimed to take advantage of the mining boom that was driving stock values skyward. Around $40 billion worth of margin loans existed in 2007. However, when the market crashed, margin calls were triggered and investors were forced to sell their shares at cheap valuations, ‘wiping out’ many who were exposed.

In comparison, although the share market has soared over the last 12 months, many investors have remained wary of taking out such loans, spooked by the horrors of the past. According to the data, just $12 billion worth of margin loans existed as of June 30 – just over a quarter of the level recorded pre-GFC.

Foolish takeaway

Whilst it is expected that margin lending will regain some of its popularity as confidence begins to return to the market, investors must strongly consider whether it is worth the risk.

Margin lending can certainly add a boost to the value of a portfolio, but it can also have long-lasting negative effects. The market is creeping higher and higher and many listed companies are no longer cheap, and margin lending does not take long-term prospects into account. So although a company could have fantastic growth potential ahead, if the stocks fall by, say, 15%, the issuer of the loan will demand a higher degree of security or else sell the shares immediately.

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Motley Fool contributor Ryan Newman does not own shares in any of the companies mentioned.

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