A margin loan is still a loan
Julie McKay argues that while margin loans have their own dynamics, those using them should not lose sight of the fact that they are a loan and they need to be repaid.
Related: Navigating the challenges of a margin call
Let’s not pretend a margin loan isn’t a loan. Investors borrow money, pay interest and are responsible for repaying the loan.
It almost goes without saying that investors should never borrow beyond their capacity to meet repayments.
Also, the driving force behind all borrowing and investment decisions must be the investor’s goals.
Having set those immutable parameters, a margin loan, or more specifically a strategy to gear financial investments, is fundamentally different to other borrowing decisions. Its distinct characteristics stem from the investments used as collateral for the loan.
Investment characteristics
Investments geared through a margin loan are divisible and liquid in all but very exceptional circumstances. Investors can sell some investments to fine tune their strategy.
It’s not possible to sell a few bricks from a home to reduce a home loan. Sale proceeds used to reduce the loan are usually received within a few days rather than a few months.
A margin loan is an interest-only line of credit; in other words, repayments don’t include a principal repayment.
This makes repayments smaller than other principal and interest (P&I) loans. An interest-only period can be set up on some loans such as home loans. However, the minimum home loan is around $300,000 on average.
At current rates, interest-only payments on that mortgage are only slightly less than $1,500 per month. A margin loan can be as small as $20,000, meaning interest payments around $130 per month at current rates.
Altogether this means a margin loan can be shaped to suit any suitable investor’s financial circumstances and goals.
Further, provided the investor doesn’t adopt a set-and-forget mentality, they can quickly adapt their gearing strategy to changing circumstances or investment performance.
Gearing decisions
Thus an investor who is considering gearing must address significantly different questions than when considering other borrowing decisions such as buying a home.
The starting question is not the maximum dollar amount they can borrow.
The starting question relates to the level of gearing that is likely to achieve the investor’s goals.
To make this decision, an investor needs to have a view on the expected investment performance over their investment timeframe; both the extent of any return and volatility (the degree by which prices can move in a day).
At its most basic level and ignoring tax, if the investor believes an investment will return more than current interest rates, gearing that investment may be a useful way to achieve their goals. If the investor expects volatility to be low, then gearing at the maximum might suit their circumstances.
However, volatility changes over time. Gearing at levels below the maximum is usually more prudent for investors with medium-term goals.
The exception to this guideline might be an investor who is prepared to closely monitor their portfolio, respond quickly to changes and who has other non-market-related sources of income and the time to replenish capital if the investment doesn’t perform as expected. This tends to describe younger investors with long-term goals.
Having decided on the appropriate gearing levels, the biggest mistake an investor can make is not to monitor their gearing strategy.
As the value of the investment rises, gearing levels fall. Conversely, as values fall, gearing levels rise. Either way, the strategy no longer aligns with the investor’s goals.
Home loan isn’t an ATM
There are anecdotes about investors drawing on excess home equity, rather than a margin loan, to gear financial investments. After the collapse of Storm Financial this behaviour is startling.
Some Storm Financial clients used a technique called “double gearing”. Clients borrowed from their home loan and used that money as their equity contribution to a margin loan.
The key issue for these clients was excessive gearing - borrowing too much relative to the total value of their assets and their ability to replenish capital from non-market related sources.
Even if overall gearing is kept at levels appropriate to an investor’s circumstances, there are deep concerns about using a home loan as a replacement margin loan.
Let’s also not pretend a home loan doesn’t have a margin call. Almost without exception (the exception mainly being reverse mortgages), a home loan includes the right for the bank to demand full repayment of the loan if the borrower is in default.
Typically, a default includes when the value of the property falls below a level acceptable to the bank. Sound strikingly similar to a margin call?
The required respond time to a default on a home loan is more likely to be 30 days rather than the 24 hour requirement of a margin loan.
However, 30 days is a long time in financial markets and could serve to make the investor’s financial situation worse (if markets continue to decline for example) rather than better.
More importantly, the collateral for a home loan is the home itself, not the shares acquired with excess equity.
This means the bank has rights to sell the home if the borrower is in default. In the chapter on the collapse of Storm Financial, the 2009 Parliamentary Inquiry found that Storm clients significantly underestimated the risk of losing the family home.
A margin loan is full recourse. This means the investor must eventually repay the loan in full irrespective of the value of the collateral - whereas a margin lender only has rights to sell the investments held as collateral.
Conclusion
It’s natural to think of a margin loan as being like any other loan. Certainly, there are many similarities. However, understanding the differences is more useful when implementing a successful gearing strategy.
The starting point is always the investor’s goals. The next step is to identify suitable investments that are expected to earn returns sufficient to overcome the costs of gearing.
These two pieces of information will then drive the investor’s decision about the appropriate gearing level. Only then does the answer to the question of how much to borrow bubble to the surface.
This is almost the complete opposite of other borrowing decisions, such buying a home, which starts with the maximum amount to borrow.
More importantly, the key to a sensible gearing strategy is regular monitoring and periodic reassessment of the first three steps outlined in this article.
Julie McKay is the senior manager, technical and research at Leveraged Equities.
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