Explaining the mechanics of margin lending

RECENT Reserve Bank statistics confirm that the margin lending industry continues to experience substantial growth, with loans outstanding as at March 2002, having almost doubled in the past three years to more than $9 billion.

With June 30 quickly approaching, and given that margin lending interest rates are currently at historical lows, many investors are looking to prepay interest in advance on new and existing margin loans.

Why margin lending?

Investors use margin lending to borrow money to increase the size of their investment portfolio, or effectively ‘gear’ their investments, which has the potential to leverage investment returns. Furthermore, investors may be able to claim a tax deduction for the interest charged on their borrowings, making margin lending an effective tax-planning tool.

Gearing to buy shares and managed funds is seen as a viable alternative to property gearing, and certainly offers some clear advantages (liquidity, diversification, investment options, fast loan approval, flexibility).

How margin lending works

Margin lenders provide a facility whereby investors are able to contribute cash and other eligible securities (shares, hybrids, managed funds) to borrow for additional investment.

Margin lenders assign a ‘gearing ratio’ to various eligible securities, which amounts to the maximum borrowing capacity available. In general, less risky securities attract higher ratios, and higher risk securities attract lower ratios.

For example, if an investor contributes $30,000 cash, and wishes to purchase National Australia Bank (NAB) shares (at a gearing ratio of 70 per cent), an investor would be able to purchase up to $100,000 of NAB shares. Of this total, 30 per cent would be considered equity, and 70 per cent considered debt. Interest would be payable on the amount borrowed – $70,000.

Implications for cash flows

If we assume an interest rate of 7.5 per cent, and a dividend yield of 4.0 per cent, we can expect the following cash flows throughout the year:

In this example (below), the investor’s portfolio runs at a net cost of $1,250 per annum, an amount which is potentially tax deductible.

The investor may also be able to receive franking credits of $1,714, taxed at the investor’s marginal tax rate, the result of which could position the margin loan to be self-funding. The leveraged benefits would come from any capital appreciation within the investment portfolio.

What are the risks?

One of the key risks of borrowing is that any investment losses are magnified. If the investor’s portfolio declined in value, the total geared value of the decline would have a detrimental effect on equity – as the debt level would remain unchanged.

Where the loan position exceeds the loan limit by more than 5 per cent, the account is triggered into margin call.

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