What is a margin loan? 

If you're looking to borrow money to invest, margin trading is one option.

A couple consider the pros and cons of taking out a loan

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A margin loan is a type of secured loan that allows you to borrow money to invest. Funds advanced under a margin loan are secured against the investments of the borrower. This is similar to the way your home loan is secured against your home.

Let's take a deep dive into everything you need to know about margin trading.

How does the process work? 

Investors seeking a margin loan will first need some starting capital (similar to a home deposit). For a margin loan, this starting capital could be cash or investments you already own.

Importantly, these investments will need to be on your lender's approved securities list (ASL). An ASL has all the investments (shares and managed funds) that the lender is willing to accept as collateral. 

Once your loan is approved, you can draw on it to purchase your investments. The additional investments will also need to come from your lender's ASL. Each security on the ASL is assigned a loan-to-value ratio (LVR) that dictates how much you can borrow against it. 

For example, suppose Zip Co Ltd (ASX: ZIP) had an LVR of 70%, and you wanted to buy $100,000 worth of shares. Your lender would provide $70,000, and you would need to fund the remaining $30,000 through cash or other collateral. 

What is a margin call?

When the equity in a margin loan account falls below the acceptable level set by the lender, a margin call occurs. Margin calls are made to ensure the margin loan does not exceed its maximum LVR. If the shares you are using as collateral fall in value, the LVR will increase. 

To ensure the LVR remains within acceptable limits, your lender may make a margin call requiring you to provide extra cash. If you are not able to provide those funds, the margin lender can sell your investments. 

Let's look at an example of a margin call in action.

Say you bought $100,000 of Coles Group Ltd (ASX: COL) shares using your margin loan. If Coles had a 75% LVR, you would need to contribute at least $25,000. The lender would contribute the remaining $75,000.

If the price of Coles shares fell by 10%, your shares would be worth $90,000. This produces an LVR of 83.3%. Your lender may ask you to top up the loan with cash or securities, or sell enough shares to bring the LVR back down to 75%. 

What are the risks?

Margin loans add leverage to your investments. If all goes well, this can help you reach your financial goals sooner by increasing the size of your returns. 

But margin trading can also amplify losses when things don't go to plan.

For example, if you invested $20,000 of your own money into an ASX share that had fallen by 10% by the time you sold it, your loss would be $2,000. If you invested $20,000 of your own money plus $20,000 from your margin loan, your loss would be $4,000 plus the costs of your loan. You still have to repay your margin loan and the associated interest, even if your investment falls in value. 

Market volatility means the risk of a margin call cannot be dismissed. If you receive a margin call in a falling market, you may be forced to sell shares and crystallise your losses. Your lender could also adjust its acceptable maximum LVR, adding to the risk of a margin call. 

You also need to pay interest on your margin loan, so any increase in the interest rate may impact your ability to service the loan. 

Is margin trading a good idea? 

This depends on the individual investor, their financial situation, and their risk profile. 

It is important that you fully understand the risks involved before committing to a margin loan. That said, there is a wide variety of margin lenders in Australia, with many having no minimum loan amount. This means even people investing small amounts of capital can use margin loans to leverage their position. 

Margin trading can also offer some tax advantages in that the associated costs can be tax-deductible. Ultimately, using a margin loan to invest is logical only if your after-tax return is greater than the costs of the investment and margin loan combined. If not, you will be taking on an increased risk for a low or negative return. 

How to choose a margin loan

If you do decide to use a margin loan as part of your investing strategy, it can pay to shop around. Terms and conditions vary between lenders, so it is important to be aware of how this can impact you. 

The range of ASL investments can differ between margin lenders, as can interest rates, minimum loan amounts, and the circumstances in which margin calls might be made. 

Before deciding on a margin lender, you should assess these factors in order to ensure the loan meets your individual requirements.

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a 'top share' is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a 'top share' by personal opinion.

As always, remember that when investing, the value of your investment may rise or fall, and your capital is at risk.

Motley Fool contributor Katherine O'Brien has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Zip Co. The Motley Fool Australia has positions in and has recommended Coles Group. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.