Margin lending is a type of loan that allows you to borrow money to invest, by using your existing shares, managed funds and/or cash as security. It is a type of gearing, which is borrowing money to invest.
How does margin lending work?
The amount you can borrow is based on your financial position as well as the allowable Loan to Value Ratio (LVR) of your existing portfolio, being your shares, managed funds or cash used as security. The LVR is the amount of your loan divided by the value of the shares or managed funds being used as security.
If the value of your security drops in relation to the loan amount, you may exceed the maximum LVR. This will trigger a ‘margin call’ and you’ll be required to either reduce your loan amount, contribute additional security or sell part of your investment until your LVR is below the maximum.
For this reason, you need to pay close attention to the value of your investments if you have a margin loan so you can take action if you are in a margin call situation. It’s important to know that the security you use against the loan can be used by the lender to repay the loan.
What are the benefits of margin lending?
A benefit of margin lending is the opportunity it provides to increase your investment exposure. Essentially, borrowing allows you access to more funds, giving you the potential to make additional investments you may not have been able to make otherwise. This can magnify market exposures with the potential to increase returns or allow new purchases to diversify your existing portfolio.
Margin lending can also have tax benefits. For example, you may be able to claim the interest on your loan as a tax deduction.
What are the risks of margin lending?
There is additional risk in borrowing to invest. If the market or your investments drop in value, then you won’t only be dealing with that loss - you’ll also have to repay the loan.
Although the additional market exposure has the potential to magnify returns, it also has the potential to magnify losses. In addition to this, any positive returns need to outperform the cost of borrowing, which can fluctuate with interest rates.
Changes to tax laws may have an impact on the effectiveness of your investment strategy.