A margin loan is a loan that is secured against shares or managed funds, in a similar way that a home loan is secured against a home. The loan allows you to purchase more investments than you could if you were using only your savings.
The use of a margin loan gives you a larger exposure to your chosen investments. This increased exposure can increase your potential gains, but importantly it can also increase your potential losses.
One of most important aspects of a margin loan is the possibility of a margin call. This occurs when the value of your investments suffer a significant fall in value, resulting in the LVR (loan to value ratio) increasing to an unacceptable level.
For example, if the LVR is set at 50%, this means the outstanding balance of your loan cannot exceed 50% of the value of your investments. If you had a $100,000 worth of investments with a $40,000 loan, this would equal an LVR of 40%, and would therefore be acceptable. If the value of your investments fell to $70,000 the LVR would increase to 57% and would therefore be above the 50% limit.
In this case, the lending will require that you reduce the LVR back below 50%. This can be achieved in three ways:
1. Pay $5,000 into the loan. This would reduce the loan to $35,000, which is 50% of your $70,000 investment value.
2. Purchase $10,000 of additional investments. This would increase your total investment value to $80,000 meaning your $40,000 loan would be back to 50%.
3. The final option that the lender will enforce if neither of the first options are taken is to sell some of your investments to reduce your loan. In this case, they may sell $10,000 worth of your investments and pay those funds off your loan. This would reduce your investments to $60,000 and your loan to $30,000, bringing the LVR back to an acceptable 50%.
The third option is the least favoured, as the margin call will invariably be caused by a decline in the value of your investments, so selling your investments at this time will mean you'll be receiving a lower amount for them. Essentially you will be 'crystallising' your losses, meaning that you won't have the chance for those investments to go back up in value when the market recovers.
Margin lending can be a great way to boost your investment returns, but it is important to consult with a financial adviser first to ensure it is the right strategy for you.