As ADF members you know a lot about managing risk. When you embark on any new endeavour, it’s good to know the risks involved so you can assess the situation and make an informed tactical decision.
Borrowing money to invest, also known as gearing, is a risky business. One of the most common ways of borrowing to invest is through a margin loan. ASIC has developed an online margin loan calculator at www.moneysmart.gov.au to help you assess the risks for yourself.
The highs and lows of margin loans
A margin loan lets you borrow money to invest and uses your shares or managed funds as security.
If your investments are successful, it can multiply your gains — but if they are not, it can multiply your losses, and leave you with a loan to repay.
Margin loans are for dedicated investors who actively monitor and manage their investments. Many people have suffered financial ruin when margin loans have gone sour. If you don’t fully understand how margin loans work and the risks involved, don’t take out a margin loan.
Because share prices move frequently, you are exposed to the risk that the shares might fall in value. To gauge the risk of your loan, lenders use a Loan to Value Ratio (LVR). The LVR is the amount of your loan divided by the total value of your shares. Most lenders require you to keep the LVR below a maximum of 70%.
If the value of your investments falls to a point where your loan exceeds the maximum LVR, you will be required to top up your investment or repay some of the loan. This is known as a ‘margin call’.
In order to meet a margin call and bring the LVR back to an acceptable level, you will have to do one of these things:
- Find extra cash to pay the lender
- Sell part of your investment to raise cash
- Give the lender additional security (e.g. security over other shares)
The risks of margin loans
- Face huge losses if the market falls
- Be forced to sell part of your investment at a low price to meet a margin call
- Get an unexpected margin call if your lender decides to lower the maximum LVR for one of your investments
In extreme circumstances you could also:
- Owe more than your original investment was worth
- Lose your home if you borrow against it for the investment
- Be forced to pay off your loan at short notice if your lender decides the investment is no longer suitable as security
Nick’s fortune dives
Nick took out a margin loan to invest in shares when the market was up and earned himself some decent money. But when the market turned sour his lender started making margin calls almost every day.
Nick did not have any money to pay his lender – all his cash was tied up in his investments. He had put up his apartment as security for the loan and was in danger of losing it if he did not make a substantial repayment to his lender. To avoid this, Nick was forced to sell most of his investments at low prices. The sale prices were so low that he was still left with a substantial debt, which continues to grow.
Managing the risks with margin loans
The first rule of margin loans is you should borrow conservatively. This means you should borrow much less than the maximum amount the lender offers you and never mortgage your home to invest in a margin loan. As a starting point, consider borrowing less than half of what the lender will give you.
You should also diversify your investment. Choose a diversified managed fund or a diversified portfolio of shares. You should spread your investments in different industries and/or markets.
Paying the interest on your loan keeps your debt under control. Most margin loans do not force you to make regular repayments; the interest can just be added to the loan (known as ‘interest capitalisation’). Making regular repayments can prevent your debt from increasing each month.
You should check your loan account regularly because the value of your investment can change very quickly. As your investment is used to secure the loan, you should ensure that you can sell the investment and repay the loan, if market circumstances change.
Have cash or security ready for margin calls. If your lender makes a margin call, you will have to respond very quickly, usually within 24 hours or less. The responsibility falls on you to increase the assets securing the loan or reduce the loan by the time set out in your margin loan agreement.
Shop around for the best loan. Margin loan interest rates and features vary so shop around for a lender that best suits you.
Make smart choices about money
Visit ASIC’s consumer and investor website, www.moneysmart.gov.au call 1300 300 630.
E-mail ASIC with topics that interest you at ADFcolumn@asic.gov.au.
Tony D’Aloisio BA LLB (Hons)
Australian Securities and Investments Commission