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Both sides of the margin loan coin

I know a lot of people got into trouble with margin loans but I have come across people who seem pretty good at investing and making money who still are doing it. Could you explain how it works and give me the pros and cons?

In simple terms, margin lending happens when, say, a bank lends you between 40 and 70 per cent of the value of a parcel of shares. So, if you had $30,000 but you wanted to buy $100,000 worth of shares, the bank would give you a margin loan for the extra $70,000.

What they lend to you depends on the quality of the share, how its price gyrates and how often it’s traded. You can access margin loans to invest in a managed fund as well.

Let’s work through the above example to explain margin loans more fully. In our example, the bank has a loan to value ratio of 70 per cent – that is a $70,000 loan for $100,000 worth of shares. Now, if the market dives like it did in 2008, your shares could fall to $80,000 and now your loan to value ration has gone from 7:10 to 7:8 which is 87.5 per cent compared to the ratio the bank wanted of 70 per cent.

If you wanted to keep the shares you would have to meet a margin call of $14,000 and that would reduce the loan to $56,000.

Smart margin loan operators might keep a buffer – an amount of money, which could be borrowed – so if the value of the shares falls, they can throw that money in to avoid meeting margin calls out of their own funds.

Lots of advisers put their clients into margin loan products on the basis that they could stand a 30 per cent fall in the stock market and so the GFC’s 50 per cent fall knocked their clients for a six.

If you want to try margin loans to turbo charge your returns, you need to take out insurance against big falls in the market. By the way, the interest on margin loans is tax deductible and that encourages many to have a go at this way to ramp up returns.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Published on: Friday, August 20, 2010

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