Ask an Adviser - What is a Margin Loan?

Top answer provided by:

David Siostrom

A margin loan is a loan secured against a financial instrument such as shares or units in a managed fund. Lenders typically lend investors an amount equal to 65-70% of the value of the portfolio being held or acquired. That is, the LVR is typically 65-70%.

The name ‘margin loan’ comes from the fact that the lender wants to keep the value of the debt within the prescribed margin (i.e. between 0% of the value of the portfolio and the nominated LVR). The value of the financial instruments on which the loan is provided are often quite volatile in the short term. This means that the value of the portfolio may also be subject to rapid change. Where the value of the portfolio falls to the extent that the level of debt exceeds the prescribed margin, the lender will require the borrower to do one of three things:

1. repay some of the loan
2. provide further assets as security; or
3. sell some of their holding and use the proceeds to repay some of the debt.

When the lender does any of these things, it is known as a ‘margin call’. Most lenders allow a little leeway in the value of the financial instruments before making a margin call. This leeway is known as a ‘buffer’. Some lenders allow a buffer of 5% over the prescribed margin of (say) 70%. This buffer is designed to reduce the need to take action when a financial instrument temporarily dips in price and the prescribed margin is exceeded.

Interest rates on margin loans are typically higher than for home loans. This reflects the fact that there is generally a greater risk that the financial instruments used as security will fall in price. This increases the risk that the lender will not be able to retrieve the loan amount. The lender increases the interest rate to compensate for this increased risk.

Margin loans can operate in one or both of the following ways:

1. as a line of credit; and/or
2. as a means of increasing an amount being invested.

To use a margin loan as a line of credit, a borrower needs to own some financial assets. They offer the lender security over these assets and, in return, the lender makes some loan monies available to them. The borrower is free to use these loan monies in any way they like; this may or may not mean that the loan is used to finance further investment.

To use a margin loan as a means of increasing the amount being invested, the borrower deposits some of their own money into the margin loan account. The lender adds some loan money and makes a purchase of financial instruments on behalf of the borrower. The lender retains a mortgage over these assets.

Many investors use margin loans in this second way to facilitate a dollar cost averaging strategy. If a borrower contributes $500 to the account each month and the lender also contributes $500, then the borrower is investing $1,000 each month. Meaning, the starting margin will be 50%.

The most obvious risk in a margin loan is that the value of the asset(s) that are used as security will fall such that a margin call ensues. To manage this risk, prudent investors keep the starting margin (i.e. the margin at the time the loan money is borrowed) well below the prescribed limit. If a lender has a limit of 70%, then a borrower may choose to borrow only 50% of the value of the portfolio. This means that the price of the assets can fall substantially before the prescribed margin is reached.

Margin loans were popular with clients up to the GFC. But harsh margin calls and high interest rates between 2008 and 2011 caused a lot of pain.Memories linger and in more recently margin loans are not as popular with clients. 

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Article by:

David Siostrom of Financial Planner Adelaide.

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