What is a margin loan and how does it work?

Most people would be familiar with the concept of borrowing to invest, after all, many Australians do just that when they buy a house. However, taking out a loan to invest in other securities is a little different – here’s how it works.

What is a margin loan?

A margin loan is a type of loan that allows you to borrow funds to invest in shares, managed funds and other securities. Although not suitable for all investors, a margin loan could help you reach your financial goals sooner, but it can also amplify your losses. It’s important to consider your financial goal, timeframe and risk appetite as an investor before deciding if it’s the right option for you.

How do margin loans work?

Taking out a margin loan is similar to taking out a home loan, as you have to pay interest and eventually repay the money you borrowed in full. However, with a margin loan, the investor’s portfolio of shares or managed funds provide the security for the loan as opposed to a house. This means that if you can’t repay the loan, the provider can sell your shares to repay the loan. T get you started, you will need to understand how the Loan to Value Ratio (LVR) and margin calls work, which we will explore below.

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What do I need to know before margin lending?

LVR

The Loan to Value Ratio (LVR) is used by the lender to measure the risk of your loan. The LVR is based on the value of a security and represents how much you can borrow as a percentage of the total value of your investment. For example, if stocks have an LVR of 70% this means the lender will loan you 70% of the value on the condition that you can provide the other 30% upfront. So an investor might have $30,000 in cash to invest and borrow $70,000 to invest. The total value of their portfolio invested would be $100,000 but they have borrowed 70% of the money.

Margin call

A margin call is issued when the equity in a margin account falls below a certain level and typically each margin lender sets its own margin requirements. A margin call can be quite scary for investors as not only does it mean that the value of your investments has fallen, but if you aren’t able to provide additional funds to boost up your portfolio, then the broker could sell off your assets to repay the loan.

Margin loans — *Image: William Potter (Shutterstock)*

Should investors buy using margin lending?

The needs of each individual investor are different, so it depends on your situation as to whether or not a margin loan is right for you. It’s a good idea to explore the pros and cons and fully understand the risks involved before taking out a margin loan.

There are a number of advantages to taking out a margin loan, including the potential to increase the size of your returns. Additionally, some brokers allow you to borrow small amounts initially and there may be some tax advantages. On the other hand, as a result of market volatility margin calls are a real risk. Lenders can also change the LVR at any point which can add another layer of uncertainty around your portfolio. Consider your tolerance for risk as while your gains may typically be stronger, any losses you experience will also be magnified.

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How to choose a margin loan provider

Each lender will have its own terms to be aware of, so it always pays to shop around. For example, some brokers don’t perform margin calls, such as with NAB’s Equity Builder. Other providers have a lower interest rate that can even be fixed. Those looking to start small may be attracted to lenders who offer same-day cash withdrawals, online application and loan management options, such as Leveraged’s Direct Investment Loan. The scope of investment products also differs between lenders. Some have a wide range of investment products that you can invest in using your loan, while the offering from others can be limited.

Here are a few things to consider before deciding on a margin lender:

your capacity to repay the loan
the interest rate on offer
the investment products you want to invest in

It may also be worth having a strategy in place in the instance that a margin call is issued on your account.

Cover image source: Tine/Shutterstock.com

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Marissa Hayden

Content Producer

Marissa is the Content Producer for the Wealth team at Canstar, and specialises in investment content. She enjoys simplifying complex financial concepts and jargon for the ‘everyday’ Australian investor. Follow Canstar Investor Hub on Facebook.

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