Margin Loans - how do they work?

A margin loan is essentially a loan which enables one to invest these borrowed funds in shares or managed funds and hence achieve higher returns than those currently being achieved.

In many ways, taking out a margin loan is similar to taking out a mortgage. The more security you can provide, e.g. cash or equity, the more money you can borrow. The Loan-to-valuation ratio (LVR) determines exactly how much you can borrow but we'll go into that in a minute. So... why would you want to take out a margin loan? Well, the answer differs for everyone. Some people want to capitalise on a strong (or bullish) share market and want to increase their exposure to particular shares which are on the rise, others simply want to increase the value of their overall portfolio through a managed fund and let the market forces do the rest. Other reasons may include diversification of earnings or taking advantage of tax concessions. In any case, the major benefit of margin loans is that it enables you to use someone else's capital to grow.

The amount you borrow will depend specifically on how much of your own capital you wish to invest and secondly, what type of investments you are going to make with the borrowed funds. The Loan percentage that applies to the types of investment is called the LVR. For example, if you wanted to invest the funds in solid, well known blue chip companies, the amount you can borrow is likely to be more than if you wanted to invest in a small diamond mining company. The higher the risk of the investment, the less you can borrow!

Now.. you must be aware that there are obviously risks involved when undertaking a margin loan. Key amongst these risks is that if the market moves against you, you have more to lose. This is where a 'Margin Call' comes into play. If the value of your shares falls below a certain level, you will be forced to sell some of your portfolio to reduce the 'borrowed amount'. The details of this vary depending on what financial institution you go through however, it is imperative that you understand how this works!!

It is worth noting that there are certain tax benefits associated with a margin loan. For example, if the interest you are paying on the loan is more than the return you are getting from the funds that are invested in the market, you are able to claim investment losses and hence reduce your overall tax bill!

Margin loans can be a very handy way to generate stronger returns or diversify your portfolio. There are many options available and most banks offer this facility so its always best to shop around. Happy hunting!

Published on May 5-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.