Essentially, it is a leveraged product. This means you have the potential to reach your goals sooner. However, leverage can be a double-edged sword, so while your gains may be magnified, so too are your losses.
An Investment Strategy
For a new investor, it is easy to imagine a margin loan as a mortgage in a share market or managed fund. It has become an investment strategy which allows you to borrow more to increase your return. At the same time, however, you will also increase your risk.
The main drawbacks of the product are the volatility of the security, which can result in margin calls, and higher interest rates in comparison to home equity loans. There is also a view that margin lending may well suit young, income rich, but asset-poor individuals who would like to invest but cannot afford the current high property prices. There is no doubt that investing in the stock market with the aid of a margin loan is a much more affordable way of enhancing your returns.
Margin Loan General Tips
- Look for different interest options, such as variable rate, fixed rate and interest in advance on some fixed rate loans.
- Choice of acceptable securities (Australian shares, managed funds, international shares and also instalment warrants).
- Level of borrowing limit, which is shown on Loan to Value Ratios (LVR).
- Buffer levels (higher buffer levels can considerably reduce the probability of a margin call).
- Brokers approved by the facility and their brokerage fees.
- Availability of discount online brokers and the link between the lender and the broker.
- Availability of online customer support, which allows convenient and user friendly monitoring of investor’s portfolio and simulating strategies.
What is a Margin Call?
Under a margin loan arrangement, it is the investor’s portfolio of shares or managed funds itself that provides security for the loan. The risk is that market fluctuations reduce the portfolio’s value to a level where it no longer provides adequate security for the loan. Once the value has fallen far enough so that the ratio of the loan to the portfolio value exceeds the maximum set by the lender, it will step in and make a “margin call”.
The lender will ask for additional funds to bring the loan-to-valuation ratio (LVR) back below the maximum level. If investors are unable to make the extra loan repayment, they may be forced to sell part of their investment.
It’s better if investors can avoid margin calls. The best way to reduce risk is to ensure that the investor doesn’t borrow up to the maximum LVR in the first place, often up to 70 per cent. In addition, lenders often allow a “buffer” of 5 per cent above the maximum LVR which acts to prevent margin calls when the LVR is only slightly exceeded. Within a short period of time (between 24-48 hours) after the investor has been contacted by the margin loan provider, quick action has to be taken to correct the situation. If the lender can?t contact the borrower, it will make the decision on their behalf, usually to sell down the portfolio.
In order to reduce the probability of a margin call, the investor should:
- Diversify their portfolio in order to reduce volatility
- Pay interest regularly
- Regularly monitor portfolio gearing level and keep away from the maximum LVR
- Have a strategy in place for meeting a margin call.