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.
How does a margin loan 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 lists 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 additional investments. The additional investments you purchase will also need to come from your lender’s ASL. Each security in the ASL is assigned a loan to value ratio (LVR) which dictates how much you can borrow against it.
For example, suppose Zip Co Ltd (ASX: Z1P) 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?
A margin call occurs when the equity in a margin loan account falls below the acceptable level set by the lender. 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.
In order 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 contributes the remaining $75,000. If the price of Coles shares fell by 10%, your shares would now 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 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 loans 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 margin loan. You still have to repay your margin loan and 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 a margin loan a good idea?
This depends on the individual investor, their financial situation, and risk profile.
It is important that you fully understand the risks involved before committing to a margin loan. That said, there are 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 loans can also offer some tax advantages in that the costs associated with them 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 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 your margin loan meets your individual requirements.