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Q&A - Margin loans made simple

Q. Lots of people got into trouble with the crash of the stock market last year because they had margin loans, or so I have been told. What are margin loans and should they be avoided at all costs? 

A. In simple terms, a margin loan is a loan with shares in a listed company held as security. For a home loan, the property is the security, so shares just take the place of a house or a unit. You can get them from banks and stockbrokers. They can also be used to invest in a managed investment fund and you can borrow between 60-80% of the value of the shares. A maximum loan to value ratio (LVR) is established and if you go above this ratio because the share price falls, you have to find some cash to maintain the maximum LVR. When you are called to make a cash payment, it is called a margin call.

Consider a case where you have $100,000 worth of shares, where you stump up $20,000 and you borrow $80,000 and your LVR is 80%. If the shares value falls to $90,000 you would be asked to reduce the value of the loan to $72,000 by putting in $8,000, as your LVR has gone to 88.8%. With a loan of $72,000 with shares worth $90,000 the LVR is back to 80%. Some smart people borrow $80,000 but buy less shares and so have a buffer which can prevent a margin call. The interest on a margin loan is tax deductible and that makes the deal pretty appealing to people with tax bills. Many people were made to meet margin calls when share prices fell, but if they hadn’t over-borrowed and had a cash buffer, they might have got through to the stage where share prices recovered and their predicament vastly improved with the rally on shares.

The important lesson is that with margin loans and negative gearing, it magnifies your profits but it also magnifies your losses! They don’t have to be avoided, but they should be done wisely and without trying to make too much money too fast. 

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, October 09, 2009

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