What is margin lending?

Although investor interest in margin lending dropped off in the wake of the financial crisis, many investors are now looking again at this type of leveraged investing, as a result of the improving stock market conditions and low interest rate environment.

Let’s take a look at what margin lending is and how investors can balance the risks and rewards around it.

Put simply, margin lending is a way of using your existing investments to increase your exposure to certain asset classes such as shares and managed funds.

The idea is that you use your existing investments, for example a basket of shares, to borrow money to increase the volume of your investment portfolio.

Margin lending often makes sense when interest rates are low (to keep the cost of borrowing down) and when an investor uses the loan to invest in stocks that pay high dividends. The idea is to use the dividends to pay down the interest associated with the loan.

It’s also timely to consider margin lending at the end of the financial year when you can pre-pay the interest associated with the loan and claim this payment as a tax deduction in the current financial year.

Margin loans are, however, not without their risks. But there have been a number of innovations recently to help investors manage these risks.

For instance, some margin lenders, including CommSec, offer a feature so that investors are alerted if their account is close to receiving a margin call. A margin call happens when the value of the portfolio associated with the loan drops, resulting in the investor having to contribute additional money to the account, or sell assets.

Investors are also generally now borrowing less when they take out a margin loan, and making sure their investment portfolios are well diversified to reduce any risks associated with this strategy.

Some margin lenders will also allow borrowers to pay to protect the initial capital that is invested in a margin loan. Although this strategy is a good way of reducing the risk attached to this strategy, it will also dampen any returns from margin lending.

In the end, however, margin lending is one of the higher risk strategies in which investors can engage. While it can potentially increase returns, it can also magnify losses.

The idea is to ensure you understand your own appetite for risk, seek appropriate financial advice, and choose a strategy that’s aligned with your investment goals and time horizon before you decide to take out a margin loan.