Margin Loans - Finance On The Lunatic Fringe, Or A Dead Cert?

Sun Herald

Sunday June 24, 2007

David Potts

If you like the sound of having your cake and eating it too, then David Potts has a few words for you.

IF THE Federal Government were fair dinkum about helping first home buyers, it would replace the first home owner's grant with a first shareholder's grant.

That way they'd have a far better chance of saving for the deposit.

After all, the hardest part about getting into property is the 10 per cent deposit you need to get the finance, especially considering the size of the mortgage you need these days.

So how would the sharemarket help?

Because it's easier to afford a loan for buying shares than it is for a home or unit. And the way the sharemarket has been going, before you know it you've built up a nice nest egg that can become a deposit for the real thing.

For instance, the 10 per cent deposit on a $10,000 portfolio of shares, or a managed fund, requires just $1000 up front. On a $400,000 property ... well, you see what I mean.

Even with a 20 per cent deposit, the norm required for a margin loan, you only need $2000 up front.

Hang on, did I say margin loan? Afraid so, but don't be put off. It's the cheapest, and possibly the only way without a credit rating to your name, for 20-somethings to get into the sharemarket.

The minimum loan is usually $20,000, but remember that requires only $6667 up front.

True, there are risks, but bear with me. Any form of borrowing is risky - it amplifies the gains you can make because you don't have to put up much equity, as well as the losses if the market goes against you.

Margin loans are a lot more versatile than they appear. We've become used to using the equity in a home to buy shares, but it works the other way around too.

If you're mortgaged to the hilt but have, say, some Telstra shares, you could take out a margin loan and use this as a deposit for an investment property. You'd want to be careful, but the fact is that margin loans can be used for other things if you already have a portfolio of shares or managed funds.

For example, if you're using a managed fund or some blue-chip shares to help pay for the kids' education, you could take out a margin loan against them - I mean the shares, not the kids - and increase the investment.

Many lenders will even let you buy shares in monthly instalments, lending a dollar for every dollar you put in, giving you twice as much to invest.

TAX TIME

OK, June 30 is only five taxable days away and you want something to cut your tax.

And without committing to super forever.

Margin loans come in to their own compared with most other ways of borrowing because they can be pre-paid, so a whole year's interest can be claimed in advance so long as it's been used for an investment.

This also lets you lock in the interest rate.

Thanks to the 30 per cent rebate from dividend franking, margin loans are the fastest way of turning gearing from negative to positive - that is, from a loss-making tax dodge to generating a profit and getting ahead.

And if you're sitting on large capital gains, a margin loan is one way of expanding your portfolio without having to sell anything and pay tax.

You've probably already heard me go on about good debt - where the interest is deductible because you've invested - and bad debt, where it isn't.

Um, you can have a bad-good debt too if the investment goes sour, though you can never have a good-bad debt.

Anyway, margin loans can help reduce the bad debt. You can use your dividends to help pay off the mortgage.

That way you capitalise the good debt, which becomes even more deductible, and pay down the bad debt. Neat, eh?

MARGIN CALLS

But what puts a shiver up the spine is the idea of a margin call. This is a demand by the lender to restore your level of equity when share prices plunge.

Say you have a margin loan of $35,000 on a portfolio worth $50,000. Well, it was worth $50,000, but there's been a severe market correction with share prices dropping 10 per cent across the board.

As a result your equity buffer has dropped from 10 per cent to zero. The lender will ask you to make up that 10 per cent quick smart.

In fact, the margin call won't be the 10 per cent drop of $5000. It's based on the amount borrowed.

Your loan limit will have also dropped 10 per cent - so the debt-to-equity ratio is maintained - which means you're over borrowed by $4500 based on the lending ratio of 70 per cent (having made a 30 per cent deposit originally).

Even that might be more than you'll have to pay. Most lenders have a built-in buffer, typically 5 per cent, to give you a bit more leeway.

BT's is 10 per cent, so there wouldn't even have been a margin call.

A 20 per cent price drop would have meant a $4000 margin call. That's due to the $7000 drop in your loan limit, with $3000 covered by the buffer.

The simplest way around a margin call is to take it on the chin and sell some stock. Whether it's the most sensible is debatable, since if the stock is any good you'd do better by buying more of it when the price dips rather than selling some of it.

Mind you, there could be a good reason everybody else is selling, in which case your lender is doing you a favour by cutting your losses.

The alternative to selling stock, possibly for less than you paid for it, is to top up your account with cash.

And no, even if the stock jumps 10 per cent the next day, you won't get your cash back. It just means you can borrow more. Anyway, the best way to handle a margin call is to avoid it. Although you can't control the share price, you can control the amount you borrowed - your gearing.

DIVERSIFICATION

The secret to a margin loan is having a portfolio of stocks rather than one or two big punts.

A diversified portfolio is a good thing in itself, but even better is the fact that lenders look at all the stocks. So if one tanks but the others are rising, there won't be a margin call.

"You can have a punt and not get a margin call," said John Daley, ANZ's head of margin lending. By the same token, you could just buy a managed fund with a margin loan.

"Put the loan into an indexed fund and you get diversification and you can forget about it," he said.

Putting up a higher deposit, or more collateral, also reduces the risk of a margin call.

As a rule you're limited to borrowing 75 to 80 per cent of the share or managed fund's value. But the average level of gearing among investors with margin loans is just 42 per cent, said Peter van der Westhuyzen of Macquarie Margin Lending.

With 50 per cent gearing and a 10 per cent buffer, the value would have to drop 38 per cent to trigger a margin call. Even borrowing 65 per cent gives you a 20 per cent comfort zone.

TURBO RETURNS

Gearing is up there with compound interest and dollar cost averaging as the trinity of investing. Margin loans work for all three.

Margin lenders are fond of producing spectacular percentage increases to show the benefits of gearing.

True enough, they are big. But remember that's because they're calculated on the deposit you put up. So if you're geared at 90 per cent, and the share price rises 10 per cent, the return is 100 per cent.

It sounds like winning Lotto, which is what they want you to think. In reality the dollar amount can be quite small. In this case, if you'd invested $1000 all up, the 100 per cent return is $100. Nice, but don't order the yacht yet. If it goes the other way, you lose your original $100, but you'll have to cough up the $900 margin loan as well.

And talk about multipliers. The funny thing about margin loans is that the more you borrow, the higher the limit becomes. In a rising market, that is.

When choosing a margin lender don't be too swayed by the interest rate, which will be tax deductible.

The table above shows there other considerations, such as the number of stocks and managed funds that you can choose. ANZ, for instance, has the biggest number of stocks and the highest gearing on leading shares. BT, on the other hand, has a bigger safety buffer.

Macquarie even has a margin loan without the margin. Its Investment Multiplier is designed for managed funds, which are naturally less volatile than shares.

Instead of a margin call the monthly repayments increase so that you pay off some of the principal, which brings your gearing back into kilter.

It's better to use bank's cash

CASE STUDY

HAVING turned his original $6000 into a share portfolio worth about $75,000 with a $50,000 margin loan, Lionel Liut is in a select group of those who love their bank. "None of it is my money. This is all from the kindness of the bank," the retired electronic technician said. In this case, ANZ.

Lionel was introduced to share trading when Colonial demutualised and he got some stock. He needed a broker, but not to sell. "I only got a few," he said. "I wanted to buy more."

His broker introduced him to margin loans and he hasn't looked back.

It wasn't an auspicious start, with Lionel getting a margin call on a dotcom stock within the first month.

"After that I woke up to the fact that when the market goes up, it must come down."

These days his portfolio would have to drop $3500 for a day to trigger a margin call.

Trading on the internet means he can't go above the 5 per cent buffer, making margin calls less likely.

"The system won't let me," he says, not altogether displeased.

"If I have a couple of thousand I have to buy something," he says. "There's a very wide range of stocks with ANZ."

The margin loan is capitalised, so he only makes payments when he sells something. Even then he's likely to use part of the proceeds to buy more shares, although the loan now stands at about $50,000, down from $80,000 at its peak.

Because he trades his portfolio of 14 stocks, borrowing more as its value increases to buy more shares, "not a penny belongs to me. Even the money I use to pay interest isn't mine".