Margin lending explained

Whatever your financial objectives, most of us wish we had more money to build wealth. With Margin Lending, you can access the funds you need to invest in shares and managed funds to help you reach your financial goals sooner. Margin loans are a powerful tool, allowing you to leverage into shares and managed fund investments, without necessarily needing to put up any other collateral as security for the loan. The shares and funds themselves form the security for the loan, but the catch is that the lender insists that you maintain a healthy buffer to ensure that they (and you) don't get caught with zero or negative equity in a falling market.

A margin call is a mechanism whereby a margin lender "calls" on the borrower for more money or additional assets to maintain the ratio of the loan-to-valuation of the portfolio. As the value of the investments drops, it increases the risk to the lender that they will not be able to recover their capital if values drop even further. To prevent this scenario - they insist on maintaining a buffer between the value of the portfolio and the outstanding debt. If that buffer becomes too small, they insist that the borrower increase it by either providing cash, additional assets, or by selling down part of the portfolio and using it to pay off some of the debt.

Borrowers typically "dread" a margin call, especially if the lender is forced to act by selling down part of the portfolio. It results in an erosion of capital currently invested, and can have the side-effect of crystallising losses in a dropping market. However, with some careful planning and advice, and a good understanding of how margin loans works, these margin calls can usually be prevented. Allowing you to choose the timing of your asset sales is important to your planning. Having a lender force that upon you due to a margin call, is usually not a good thing!

As an aside, there is a counter argument that a margin call in a falling market is not such a bad thing, as it enforces an effective stop-loss mechanism, selling down assets before the capital is eroded too far. With outstanding margin loans, this is even more important, since you really don't want to be left with a debt to service but no asset. But these arguments and strategies are beyond the scope of this article, so we'll leave them for another time.

Margin calls can be a worrying issue for investors, especially in a market that's already dropping. Being forced to sell some of your shares or units at this time may not be part of your plan! With some care and planning, and some good professional advice, you can be prepared for the situation where a margin call arises, or perhaps even avoid them all together.

Published on October 10-th, 2007 in Personal Loans
Damon Rasheed is the CEO of Rate Detective, an Australian financial service comparison sites specialising in Life Insurance, Income Protection Insurance and home loans. Damon holds a Master's Degree in Economics from the University of Melbourne and has been involved in many start-up internet businesses.

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