Understanding margin loans: risks, benefits and unique characteristics

Technical resource

Margin loans are a type of investment loan and have similar risks and benefits as other gearing strategies, however they also have some unique characteristics.

Margin loans are loans specifically designed to finance investments in shares or managed funds. In addition, existing shares or managed funds can be used as security to unlock equity.

When establishing a margin loan, the lender will set a borrowing limit. The limit is primarily determined by the perceived volatility of the shares or managed funds to be acquired. In addition, a credit assessment is made of the borrower’s financial position to ensure ability to service the debt without over-reliance on the investment’s income.

Example

John has a managed Australian share fund valued at $30,000. He’d like to increase his investment portfolio and diversify into international shares. A margin loan may allow John to borrow up to 70% of the value of his investment and therefore, he is required to provide 30% equity. His $30,000 portfolio would allow him to borrow $70,000, giving him a combined portfolio valued at $100,000.

What is a margin call?

A margin call is a demand by the lender to bring the loan back within the maximum loan to valuation ratio (LVR). This occurs when the market value of the portfolio falls to such an extent that the LVR exceeds the maximum LVR set by the lender.

Example

Sharon has an existing share portfolio worth $35,000 and takes out a margin loan of $65,000 to buy additional Australian shares. Her total share portfolio value is now $100,000. Her LVR is 65%. This is 5% less than the maximum LVR of 70% set by her lender. Six months pass and her loan amount is still $65,000 but the value of her portfolio has fallen to $90,000. So now her LVR is 72% – exceeding the 70% maximum. She receives a margin call from her lender to bring her LVR back down below the maximum. In this situation, Sharon needs to do one or a combination of the following:

  • reduce the loan amount by repaying at least $2,000 off the loan

  • reverse additional securities of at least $2,858 to increase the portfolio value (and therefore reduce the LVR)

  • sell at least $6,667 of the portfolio and use these proceeds to repay part of her loan.

If the margin call is not paid, the lender will sell securities in the portfolio to reduce the balance.

Some lenders offer a ‘buffer’ on their margin loans. This means the lender won’t issue a margin call until the LVR exceeds the maximum LVR by a specified percentage.

Different portfolios have different maximum LVRs.

The table below shows how much the market value of a portfolio may fall before a margin call occurs assuming a 10% buffer.

Maximum LVR

70%

60%

50%

40%

30%

70%

13%

25%

38%

50%

63%

65%

-

20%

33%

47%

60%

60%

-

14%

29%

43%

57%

55%

-

-

23%

38%

54%

50%

-

-

17%

33%

50%

What are the benefits of a margin loan?

In addition to the usual benefits of gearing:

  • You don’t need to own a home to obtain a margin loan.

  • You can eliminate the stress of timing the market using dollar cost averaging. Many margin loans offer a regular gearing option, enabling an investor/borrower to automatically invest regular instalments. This helps avoid the problems of timing the market and trying to choose the best time to invest.

What are the risks of a margin loan?

In addition to the general risks of gearing, there is a risk that if the investments underperform and margin loan repayments are not met (including margin calls), the default will mean the lender can enforce their right to their loan repayments by selling not only the geared investment, but also the borrower’s personal assets if the investment used as security is insufficient to meet the outstanding loan. This may result in the redemption of investments at an unfavourable time and price.

Tips to reduce the risk of a margin call

  • Don't borrow the maximum amount.

  • Diversity investments to help reduce volatility.

  • Make regular interest payments rather than capitalising the interest.

  • Reinvest income produced from underlying investments to reduce the LVR.

  • Check the LVR on a regular basis and maintain a cash reserve for margin calls which usually need to be made within 24 hours.

Next: Your guide to gearing

There are a number of ways you can gear an investment and a number of investments you can hold with gearing.
Client resource

Contact BT Technical Services for more information

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