What is a margin loan?
A margin loan is a specific kind of loan that allows you to borrow money to fund your investments and use your existing portfolio of shares or managed funds as security.
On one hand, a margin loan can be used as an investment tool to expand your portfolio, diversify your investments and potentially increase your earning.
On the other hand, taking out a margin loan can actually be a pretty risky move.
Margin loans are best suited to seasoned investors who actively manage their portfolio and thoroughly understand the risks involved, not only with investing in shares generally, but also with borrowing money in order to do so.
How does a margin loan work?
A margin loan is similar to a line of credit loan - you can borrow up to a certain amount, depending on the maximum loan-to-value ratio available and your borrowing power, and you’ll pay interest on what you borrow. But there are a few key differences to be aware of.
One of the most important differences to understand is what’s referred to as a “margin call.” If the value of your investments drops enough that your LVR goes above the maximum allowed on your loan, your lender makes a margin call. You then need to pay off some of your loan, sell off some of your investments or come up with some extra security to bring your LVR back down to the right level.
Here’s an example, using share investment. Say you have an existing share portfolio worth $50,000. You then take out a margin loan with a maximum LVR of 70% and borrow an extra $80,000 to invest with, giving you a total portfolio value of $130,000.
That means the loan is about 62% of your portfolio value, giving you an LVR of 62%. If the market then changed and the value of your shares dropped until your portfolio was only worth $100,000 in total, your loan would be a larger chunk of that, bringing your LVR up to 80%.
At that point, your lender would make a margin call and you’d have to either increase the value of your portfolio or pay off some of your loan until you were back under the 70% LVR threshold.
What risks are there with margin lending?
Margin loans unlike term deposits can be a pretty risky investment option for anyone who isn’t well-versed in the hazards and fine print that come with them. So before you consider one of these loans, it's important to consider what can go wrong, for example:
- If the market value of your shares falls, you could suffer huge losses. This is bad enough when you’re investing with your own money, but is even worse when the money you’ve lost was borrowed to begin with.
- If you get a margin call because your LVR climbs above the maximum allowed, you may wind up having to sell some of your investments to pay off more of your loan.
- In this case, you’ll have to sell at the current market value - which means if your investments are in bad shape, you’ll likely have to dip into your savings or sell off other assets as well to cover the loan repayments.
- If your lender lowers the maximum LVR on your margin loan - for example from 75% to 70%, you might need to pay off more of your loan or increase the value of your shares to make sure you’re meeting that requirement.
- If the market turns sour, you might wind up owing more than your original investment. This can spell major trouble for your finances and it’s not as uncommon as you might imagine. Basically, keep in mind that once you’ve taken on a margin loan, if things do go wrong, it will hit you much harder than it might have otherwise.
- Lenders can also decide that your investments are no longer acceptable security - for example if you buy some risky shares - and you’ll need to pay your loan off completely, sometimes with quite short notice.
One major risk area when it comes to margin loans is that many lenders don’t require you to make minimum repayments - instead, the interest charged is just added to your loan amount. This is something to keep a close eye on, because it could leave you with a much bigger loan than you bargained for and you might find it difficult to pay off in the end.
As a general rule, if you don’t fully understand margin loans and all the risks involved with them, then the best strategy is probably to steer clear.
But for savvy investors, a margin loan can be a useful tool for maximising returns. Below, we’ve answered some of the most commonly asked margin loan questions below to start you off on the right foot.