Pros And Cons Of Margin Lending

Originally Authored by Christine Thelander 

Most Australian adults are familiar with the concept of borrowing to invest, with approximately $9.35 billion (according to the ABS) currently outstanding as loans for investment housing alone. As with borrowing to invest in property, the rationale for borrowing to invest in shares or managed funds is to access a tax-effective source of funding to purchase an asset that will hopefully increase the capital value.

What’s the difference between a margin loan vs property investment loan?

The main difference between a loan sourced for property investment and a margin loan is in the security held: a standard investment loan is generally held against either the property being purchased or equity in the borrower’s own home, whereas a margin loan is secured against the value of the shares being purchased. This difference in security held does, of course, change the associated risk of the loan; with shares and managed funds being priced daily, fluctuation in the value of the security is far more likely and this can lead to a margin call being made.

It’s important for would-be margin loan investors to carefully weigh up the pros and cons before proceeding and to seek professional, personalised advice. As a starting point for discussion, a brief list of some margin lending pros and cons is as follows:

Some potential benefits of margin lending

The obvious benefit of margin lending is that it allows you to potentially build wealth much quicker than you would with just your own savings. Some other benefits include:

1. Ability to borrow without the need for property equity

Many people borrow money and use their homes as equity. But with high property prices around Australia, homes are not widely affordable. Margin loans can be borrowed without property equity, instead of using the value of the shares as the security for the loan.

2. Ability to borrow small initial amounts

Although some margin lenders don’t lend out anything less than $20,000, most these days have no minimum loan amount. This means that even small investors can utilise margin loans in the hope of leveraging their gains.

3. Ability to build regularly on the loan and investments

Like a home loan, you can borrow more additional funds from a margin loan if you want to buy more shares, provided the extra loan does not push your LVR above the bank’s maximum. This can be handy when you are suddenly very confident in the future performance of a particular stock and want to buy a large amount that you don’t currently have in cash. Or alternatively, is a useful way to set up a regular savings program.

4. Highly liquid form of investment and lending

Unlike houses, shares are very liquid – meaning they can be converted to cash a lot quicker. This also means that the margin loan can be repaid a lot quicker through the selling of shares, as opposed to a mortgage which is usually fully repaid after the sale of the house – which can take a lot longer.

5. Can be a tax-effective form of lending

The interest charged on the margin loan is tax-deductible, which makes it a reasonably effective form of lending. Also, you can prepay your interest on the loan for the next 12 months and bring a tax deduction against income for the current financial year.

6. Potential to magnify gains

Since the margin loan gives you more money to invest, you can potentially make bigger gains if the share market is rising. For example, if you invested $10,000 of just your own cash in a stock, which grew by 10% by the time you sold it, you would make a pre-tax gain of $1,000. But if you had invested $10,000 cash plus a margin loan of $10,000 in that same stock (total share ownership of $20,000) you would have made a pre-tax gain of $2,000. Obviously, the after-tax costs of the loan (your current losses) would need to be deducted from this gain.

Some potential risks of margin lending

While margin lending gives the potential for investors to magnify their gains in a rising share market, any form of borrowing to invest risks the potential of magnifying losses. When borrowing via a margin loan to invest in shares or managed funds, this risk is greater due to the highly liquid nature of the investment. Many investors fell into financial ruin after their margin loans were impacted by the GFC and are cautious to use them again.

1. Risk of a margin call due to share market volatility

Shares are the most volatile out of the four main asset classes, rising and falling every day. If your shares were to suddenly nosedive and you had a margin loan on those shares, you could expect a margin call.

2. Risk of having to crystallise losses by being forced to sell into a falling market

Having a margin loan means that you are not as easily able to ride out periods of downturn. This is because when the value of your portfolio dropped and has brought your LVR above the lenders maximum LVR and buffer, you will receive a margin call. If you do not have the cash to meet the margin call, you may be forced into selling your shares at possibly the lowest point of the downturn.

3. Potential to magnify losses

In the same way, as a loan has the potential to magnify your gain in a rising share market, a loan also has the potential to magnify your losses in a falling share market.  For example, if you invested $10,000 of just your own cash in a stock, which fell by 10% by the time you sold it, you would make a pre-tax loss of $1,000. But if you had invested $10,000 cash plus a margin loan of $10,000 in that same stock (total share ownership of $20,000) you would have made a pre-tax loss of $2,000. Obviously, the after-tax costs of the loan (your current losses) would need to be added to this amount, further compounding the total loss.

4. Risk of LVR changes imposed by the lender

Lenders can adjust their acceptable maximum LVR which can put you at further risk of a margin call.

5. Risk of interest rate rises affecting the ability of the borrower to service the debt

If you have a variable rate on your margin loan, an interest rate rise will mean there is more interest to pay on your debt. 

This list is by no means exhaustive and, as mentioned, would-be investors should use it simply as a starting point for discussion with their personal financial adviser. Margin loans should not be used by investors who are not fully aware of how they work and what the risks are.

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