Margin loans 101

Margin lending can be a high risk, high return investment strategy. It's a great way to squeeze the investment value out of your capital, but the unwise - or unlucky - investor can lose money just as quickly.

What is a margin loan?

Margin lending supplements your investment equity with extra capital, on credit. It allows you to take a larger position on the share market or in a managed fund, so your profits are compounded (ditto any losses).

For example - If you have $10,000, and take out a margin loan of a further $30,000, you can then invest the full $40,000 and quadruple the value of any gains (less your interest payments). A 10% profit on your share price and dividend over one year would be worth $4000, or 40% of your initial equity.

Am I right for margin lending?

In general, you need to be prepared to accept the added risk of losing your equity. Ideally, you should be in a financial position to cover interest repayments as well as ride out a drop in your shares' value should the market turn. Note that changing life circumstances (getting a mortgage, getting pregnant) could affect your ability to pay the interest on a loan.

If you like the idea of a margin loan but wouldn't know what to do with the money, investment funds can sort out which shares (etc) to buy for you.

Margin loans explained

First up there's Loan-to-value ratio, or LVR, which is set by the lender. This dictates how much you can borrow in proportion to how much you have to invest. Your equity might be cash, or other shares (operated personally or in a managed fund.

For example - An LVR of 75% means you need to fund 25% of any investment. So to purchase shares worth $40,000 will require $10,000 in initial equity.

Next, there's the sting of variable and fixed interest margin loans. Variable loans will fluctuate with market rates, usually based on the Reserve Bank cash rate; you typically pay interest at the end of each month.

Fixed interest rate margin loans can be paid in advance - which can also be a tax deduction.

Most margin loans are interest only, which means you don't have to pay off the loan, only service the interest.

Margin loan features

Margin lending comes with a variety of options, and you'll need to know what you want from your investment loan before diving in.

• Interest paid in advance lets you pay down the interest owed on the loan up front, for tax or other purposes.
• Options are more sophisticated investment avenues that allow you to take advantage of more subtle market conditions. Not all margin loans allow for investment in options trading.
• Instalment gearing lets you grow your investment over time with regular contributions on top of your initial capital. It's a great option for first-time investors who want to take advantage of a margin loan to accelerate their portfolio growth.
• International shares aren't available to all margin loans.

Compare margin loans with interest paid in advance, options trading, instalment gearing or international shares.

Margin loan risks

Many investors aim to pay off margin loan interest with the money earned by dividends. However, conditions change, and if those dividends aren't enough you'll have to cover the interest repayments out of your pocket, or be forced to sell your shares.

The greater risk is a margin call, which is when your loan-to-value ratio (LVR) exceeds the limit set by your lender. You then need to add to your equity or sell down your shares.

For example - In the case of our 75% LVR margin loan, we invested $10,000 of our own plus the $30,000 we borrowed. If, instead of our 20% gain, our shares drop by 10%, the value of our holding loses $4000 for a total of $36,000. Since $30,000 of this is borrowed, the LVR has shot up to 83.3%, or well above the 75% maximum. We'd either need to add to our initial equity or cut our losses sell off the shares at their lower price.

Minimising your margin loan risk

Few of us can predict the market, but sound investments should turn a profit in the long run. Here are some top tips:

• Don't max out your maximum LVR: there's a difference between cleverly leveraging your equity and a greedy grab for cash. If you start out below the LVR there's less risk of a margin call should the market drop.
• A longer-term investment timeframe (of five to ten years) will let you push through fluctuations in the market.
• Extra capital to service interest or a short-term market drop can be vital to secure your investment portfolio in times of crisis when even solid stocks can drop.
• Most advisors recommend you don't draw against your home to secure a margin loan.

Search the margin loan market for the best deals on interest rates and margin lending features. Before committing, see your financial professional for more advice.