Margin lending explained

Using a margin loan to amplify your investing power can be an effective way to build wealth, diversify your portfolio and could offer tax benefits as well. However, just as it has the potential to grow your wealth, if stocks go down in value your losses will be amplified as well. It’s important to weigh up both the benefits and the risks when thinking about investing with a margin loan.

How does a margin loan work?

A margin loan uses existing shares, managed funds and cash as security. These existing assets are used to calculate your Loan to Value Ratio (LVR), which determines how much you can borrow. Once your borrowing limit is established, you can use available funds to purchase further approved investments (shares, managed funds etc). Your new and existing investments are combined to form your total portfolio.

Interest on a margin loan is calculated daily; but how it is paid will depend on the loan. Some margin loans allow interest to be paid in advance.

What are some of the benefits?

Potential to increase your investment returns - a margin loan gives you access to a larger amount of capital, allowing you to invest more than would be possible using just your own money. With more money to invest, you can build a larger portfolio and increase your potential for greater capital gains and investment income.

Portfolio diversification - diversification is a recognised strategy to potentially reduce investment risk without sacrificing long-term returns. Because a margin loan gives you more money to invest, you can spread your investment across a broader range of assets or industry sectors to build a more diversified portfolio.

Unlock the equity in your existing investments - because you can borrow money against your existing investments, a margin loan enables you to access money for investment purposes without having to sell your investments and therefore not trigger a capital gains tax event.

Potential tax advantages – depending on your circumstances, you may be able to claim your loan interest expenses as a tax deduction to the extent that borrowed funds are used to acquire assets for the purpose of deriving assessable income such as dividends and income distributions.

What about the risks?

Amplified losses - while borrowing to invest can increase your potential for greater returns, it can also increase the potential for greater losses if your investments perform poorly. If the value of your portfolio falls, your losses will be greater than if you had only invested your own money.

Market movements - the value of securities may not go up, or if they do, the increase in value may not be sufficient to cover the costs of the investment.

Interest rate changes - the interest rate applicable to your margin loan can be varied at any time (except on any amount for which you prepaid interest or have entered into a fixed interest rate). If the interest rate rises, your interest repayments may be more than your investment returns, and you may not be able to meet your interest payments. This may result in a margin call.

Margin calls - in a volatile market, the value of your margin loan portfolio may fall to a level where it no longer provides adequate security for your margin loan. If this happens, there may be a margin call and you’ll have to find an alternative source of funds to repay the margin loan.

What is a margin call?

From time to time, your loan balance may exceed your borrowing limit for several reasons including a fall in the market value of your investments, changes to investment LVRs, or delisting of a company. If your loan balance exceeds your borrowing limit by more than the allocated buffer, a margin call will be triggered.

How do I manage a margin call?

When a margin call is triggered, you will be required to restore your loan balance back to your borrowing limit by doing one of the following by 2pm (Sydney time) on the following business day:
 

1.       Make a loan repayment to reduce your outstanding loan balance; or

2.       Transfer/lodge additional acceptable securities (held externally) into your Margin Loan to increase your borrowing limit; or

3.       Sell securities held on your Margin Loan to repay a portion of the loan; or

4.       Any combination of the above.

Please note: If you are required to clear a margin call, you must restore your loan to the borrowing limit. Returning your loan back to within the buffer will not be sufficient.

If you don’t clear your margin call in full within the required timeframe, some or all of your investments held as security for your loan may be sold to reduce your loan balance to your borrowing limit.

How do I minimise the risk of a margin call?

It is important that you closely monitor your margin loan facility on a regular basis and promptly act if you are in a margin call position.

To minimise the risk of a margin call, you should consider:

• Depositing additional funds
  
• Providing additional acceptable investments as security
• Paying the interest monthly instead of having the interest added (capitalised) to your loan balance (for variable interest rate loans)
• Arrange for dividends and distributions to be credited directly to your variable rate loan
• Not borrow up to the maximum
• Diversify your portfolio across a number of investments and industry sectors to lessen the impact of poorly performing investments

What is the buffer?

As investment markets are by nature volatile, a buffer is added to the LVR of each acceptable security to ensure small fluctuations in the market value of your investments do not result in a margin call. It is especially useful if you have borrowed up to the maximum permitted. The buffer gives you time to take the appropriate actions to return your loan to a suitable security position and reduce your chance of a margin call.