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Email. reidcont@tpg.com.au
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www.reidconsultants.com.au

1^st August 2006

Margin lending is the practice used to describe borrowing money from lenders for the specific purpose of acquiring shares or units in a managed fund (securities), where the lenders take security over those shares or units themselves. It is like taking a mortgage – in the sharemarket.

Ways to borrow money

There are numerous ways you can borrow money to purchase shares and/or managed funds. The differences all relate to the risk that the lenders perceive and the security that they have available (that you offer) and the interest rate they will lend to you based on their perceived risk. The better the security, the lower the interest rates offered.

• Personal Loans - unsecured
  These can be used for (almost) any purpose. As they are unsecured, the lenders interest rates are higher than for other lending (other than credit cards), rates are around the 11.5% to 13%.
  
• Margin Loans
  These are loans secured by the shares or managed funds themselves. The rates vary on size, starting from between 8% to 9% depending on lender and features, down to 7.75% for large loans. They act like a flexible line of credit facility.
  
• Equity in Property
  This could be your own home or an investment property. As the (extensions of the) loan is secured by your property, normal home loan rates apply, anywhere between 6.5% to 8% depending on features, size and lender.

Loan to Value Ratio (LVR)

Margin loans allow you to borrow so you can purchase more shares than you otherwise could afford from your own savings. This is called leveraging. As an example, you have $3,000 available, you could potentially borrow a further $7,000 to purchase shares worth $10,000. This LVR is calculated as 70% LVR

Each lender has a list of securities (shares, managed funds and wraps, listed property trusts etc.) that it will accept, each with a specified percentage of market value, being the maximum amount it will lend against that security. These range from 30% to 80% (more usual upper limit is 70%).

The main drawback (outside the higher interest rate) is that the volatility of the securities, being the movement in the shares market price, can cause a margin call which the investor needs to meet. If the market share price falls and that it results in the LVR being exceeded, then the lender will make a margin call requesting you provide additional cash to bring the security back within the maximum LVR limit. Alternatively you could sell some of your security. An example may clarify this operation.

The effect of a 10% negative share price movement has resulted in a margin call being made for an additional $700 that you have to meet.

Leveraging, the use of other peoples money, magnifies your gains OR your losses.

Margin Calls

There are strategies that can be used to reduce the risk of margin calls.

• having a diversified portfolio,
• leveraging at a lower LVR than the maximums the lender allows,
• prepay interest (potential tax benefit) or regularly repay interest,
• have access to additional cash or cash reserves to meet margin calls

Margin calls are normally required to be met within 24 hours (some lenders up to 3 days), so it is wise to avoid having margin calls being made. Read the fine print, some lenders will sell your security without notifying you to meet these margin calls.

Margin Lending Strategy

The purpose and reason to invest in the share market directly needs to be understood and form part of your overall wealth creation strategy. The mechanics of borrowing, using which type of loan product needs to be considered to make the most effective use and to minimize costs of those funds.

If margin lending is the right strategy, then features to consider include:

• different interest rate options, fixed/variable/allow prepayment of interest etc.,
• borrowing limits (LVR's),
• the choice of which shares and managed funds,
• buffer limits,
• period for margin calls to be met,
• availability of support, particularly online broker support

Profile of Users – with changes to the superannuation rules and marginal tax rates, these products are perhaps less attractive than pre May 2006. However they can still have benefit and be suitable for the younger investor who is income rich and asset poor, who wants to create wealth longer term and cannot afford to invest directly in property or does not want to commit to an area yet.

Give me a call to discuss how these products fit into your life stages wealth creation strategies

Helping People through Finance