Margin loans
Are you one of many Australian investors who use a margin loan to increase your investment in the sharemarket? Are you thinking of taking out a margin loan?
Borrowing to invest can potentially result in higher returns, but it also magnifies your potential losses if the value of your investments falls.
Margin loans are not subject to the same disclosure requirements as many other financial products and services in Australia. They are also not subject to the same regulation as most consumer loans, such as a car loan.
For these reasons, whether you have a margin loan, or are thinking of getting one, make sure you understand how margin lending works, what the risks are and what’s at stake for you. This information should help you.
Investors, especially those not experienced with margin loans, should also think about getting professional financial advice before borrowing to invest.
What is a margin loan?
A margin loan lets you borrow money to invest in shares and other financial products, using existing investments as security. Borrowing money to invest in this way, also known as ‘gearing’, can increase the gains from an investment, but also multiply the losses. Margin loans are offered by a wide range of financial institutions and are often available online.
How do margin loans work?
Let’s take shares as an example. When you borrow money to buy shares, there is a risk that the shares fall in value and you cannot repay the loan. To reduce this risk, margin lenders take security (ie a mortgage) over the shares you buy with the loan, so that the shares can be sold to repay the loan. This is no different from what happens when you borrow money to buy a house, except the share market rises and falls more rapidly than the housing market.
Because share prices move frequently, both you and the lender are also exposed to the risk that the shares might fall in value. If this happens, the shares could be worth less than the loan, creating problems for you and a shortfall of security for the lender.
To protect themselves against this possible shortfall, margin lenders limit your level of gearing to a set percentage (known as the Loan-to-Value Ratio or LVR) of the value of the shares. Commonly, LVRs are set at a maximum of 70%. This means that you have to make up the difference (ie 30%) with your own money. This difference is the 'margin'.
Some shares are riskier than others. Margin lenders have an ‘approved’ list of shares that sets out the LVR or amount of gearing allowed for each share.
If the value of your investments falls to a point where the value of the loan exceeds the maximum LVR, you might be required to top up your margin to keep the loan secure. This is known as a 'margin call'.
You can minimise the risk of margin calls by borrowing conservatively – that is, by borrowing less than the maximum LVR allowed by the margin lender. Read more about managing your margin loan and meeting a margin call.
Worked example
Note: these examples do not include interest costs.
Bob has $10,000 invested in shares. His colleague Jane also has $10,000 invested in shares and borrows another $10,000 to invest in shares using a margin loan, giving her a total portfolio worth $20,000. Because Jane’s loan represents 50% of the value of the portfolio, Jane has a Loan-to-Value Ratio (LVR) of 50%.
The margin lender allows a maximum LVR of 70%. If this ratio is exceeded, a margin call is triggered.
Scenario 1 – value of shares goes up by 10%
BOB | JANE |
Portfolio value | Shares go up by 10% | New portfolio value | Portfolio value | Shares go up by 10% | New value of portfolio |
$10,000 | $1,000 | $11,000 | $20,000 | $2,000 | $22,000 |
In this scenario, Bob has made a gain of $1,000 or 10% while Jane has made a gain of $2,000. If Jane were to sell the shares and repay the loan, she would have made a gain of 20% (ie the margin loan increased her gains).
Scenario 2 – value of shares drops by 10%
BOB | JANE |
Portfolio value | Shares drop by 10% | New portfolio value | Portfolio value | Shares drop by 10% | New portfolio value |
$10,000 | $1,000 | $9,000 | $20,000 | $2,000 | $18,000 |
In this scenario, Bob’s loss is $1,000 and Jane’s loss is $2,000. If Jane sold her shares and repaid the loan, she would have made a loss of 20% (ie the margin loan magnified her losses).
Jane’s loan now represents 55% of the value of her portfolio (ie the LVR is now 55%). No margin call is triggered in this scenario.
Note: When you buy shares and other investments with a traditional margin loan, you get the legal title to them. This means that you are the beneficial owner of the investments, and get any income and voting rights.
A margin loan is different from a stock lending arrangement. With a stock lending agreement, the legal title, or ownership, of the investments is transferred to the lender. More about stock lending.
Some lenders may refer to stock lending arrangements as margin lending, so you should check the terms and conditions carefully or seek financial or legal advice. Because margin lending is not regulated like other methods of investing and does not require standard information to be disclosed in a product disclosure statement, it is particularly important to check the terms and conditions as well as marketing brochures provided by the lender. |
Meeting a margin call
Like most other loans, you have to pay interest on the amount borrowed under a margin loan.
However, you might also be required to meet what is known as a 'margin call' if the market value of the underlying investments falls and your level of gearing exceeds the level permitted by the margin lender. A margin call requires you to increase the level of assets securing your loan.
Returning to Bob and Jane, the following example shows how a margin call is triggered.
Scenario 3 – value of shares drops by 35%
BOB | JANE |
Portfolio value | Shares drop by 35% | New portfolio value | Portfolio value | Shares drop by 35% | New value of portfolio |
$10,000 | $3,500 | $6,500 | $20,000 | $7,000 | $13,000 |
In this scenario, Bob’s loss if $3,500 and Jane’s loss is $7,000. Jane’s loan now represents 77% of the value of her portfolio, which is more than the maximum permitted LVR. A margin call is triggered and Jane must act quickly to meet it to bring the LVR back to a maximum of 70% or below.
In order to meet a margin call and bring the LVR back to an acceptable level, you will typically have to:
- find extra cash to pay the lender or
- sell part of your underlying portfolio to raise cash or
- give the lender additional security (eg over other shares).
You will have to respond quickly, often within 24 hours or sooner, if your lender makes a margin call. This means that you must:
- keep a daily watch on your margin loan account and
- have cash or additional security readily available.
Ideally, you should have access to up-to-date market information, such as that available online through many stockbrokers. Margin lending is for people who are actively engaged with their investments.
If the market value of your portfolio falls substantially, then you should be prepared to meet more than one margin call.
Your lender might even be under no legal obligation to contact you when a margin call happens. The responsibility falls on you to know that you must increase the assets securing, and to do so by the time set out in your margin loan agreement.
| It is basically the risk of margin calls that differentiates margin lending products from many other secured loans. The fact is that the underlying security has greater potential for short-term fluctuations in value than, say, residential property. In the worst case scenario, the lender might sell your investments at a loss if the loan is in default. In that case, you have to make up the loss. |
Lenders' rights
Most margin lending products also give the lender the right to sell some or all of your investments. The lender might do this if, for example, you cannot meet a margin call, or if there is a significant fall in the market as a whole, or if the lender varies the LVR it has on a particular share.
Your loan agreement might let the lender change the LVR for an investment at any time without notice to you and this could trigger a margin call. If your lender decides the shares you have provided for security are no longer suitable, you will have to close out or repay your loan at short notice.
The lender might be under no legal obligation to contact you before selling your investments, and might be entitled to sell any of your investments to meet the terms of your loan agreement.
Your loan agreement might also allow the lender to close your account and demand repayment in full in various situations, including significant falls in the market over which you have no control.
Interest repayments
Lenders charge interest monthly on your margin loan account. Unlike other types of loans, in most cases you do not have to make regular interest repayments. The interest you are charged is just added to the loan. This means that unless you make the repayment your gearing level (or LVR) will increase each month.
Managing your margin loan
You should also make sure that you are aware of, and understand, all of the terms of your loan. You should regularly review your ability to make interest payments and margin calls that might arise.
FIDO offers the following key tips to help investors manage their margin loan:
- monitor the market and your loan account regularly (preferably daily)
- maintain a gearing level (LVR) that gives you a buffer if the market value of your investments falls
- have cash or additional security readily available to meet a margin call
- check the terms of your loan agreement to find out in what circumstances your investments might be sold up under the loan agreement
- credit or reinvest dividends and distributions to your account to reduce gearing levels
- make regular interest repayments to maintain your gearing levels
- diversify your portfolio (ie do not invest in just one or two shares) to manage investment risk
- set aside some money in case of emergency
- seek professional financial advice.
Questions to ask
If margin lending is something you’re interested in, ask your broker, adviser or the financial services provider you are dealing with to explain:
- when a margin call might be made under your loan agreement
- how to respond to a margin call
- the risk of "negative equity" (when the amount that you borrow exceeds the value of the underlying investments)
- the tax implications of margin lending
- whether you keep full ownership of your investments.
Note: When you buy shares and other investments with a traditional margin loan, you get the legal title to the investments. This means that you are the beneficial owner of the investments, and get any income and voting rights.
A margin loan is different from a stock lending arrangement. With a stock lending agreement, the legal title, or ownership, of the investments is transferred to the lender. More about stock lending. |
FIDO Website: Printed 07/29/2010
