Margin Lending

Margin lending is borrowing money to invest in shares or managed funds, using your existing portfolio as security for the loan. The loan-to-value ratio - the LVR - sets how much you can borrow against the portfolio. The range runs from roughly 40 to 75 percent depending on what you hold, with blue-chip shares at the top and volatile small caps at the bottom. The borrowed money buys more of the same assets, so every gain and every fall applies to a larger base. It is the share-market version of gearing - the same mechanism negative gearing applies to property, with the same amplification and the same exposure to being wrong.

The Australian feature is the margin call. When the portfolio falls and the LVR climbs above the approved ratio, the lender demands action within 24 hours: deposit cash, sell shares or provide extra security. ASIC's guidance treats margin loans as high-risk products for a reason. Lenders can also change the approved ratio at any time - during the 2008-09 crisis they cut ratios overnight, triggering calls on borrowers who were within limits the day before.

Interest on the loan is tax-deductible against investment income when the borrowing genuinely buys income-producing assets. That is why the strategy is sometimes called negative gearing on shares.

Walk the gearing. A $100,000 portfolio with $50,000 borrowed buys $150,000 of assets at a 33 percent LVR against an approved 40. The market rises 20 percent and the portfolio reaches $180,000; minus the $50,000 loan, the equity is $130,000 - a 30 percent gain on the original $100,000. The market falls 20 percent and the arithmetic inverts: equity of $70,000, a 30 percent loss. The amplification is structural - the geared portfolio owns $1.50 of assets for every $1.00 of your money, and every percentage point the market moves lands on that larger base.

The margin call is the second mechanism, and the expensive one. The market falls 20 percent, the portfolio sits at $120,000 with the $50,000 loan unchanged, and the LVR climbs to 41.7 percent - above the approved 40. The lender issues a call with 24 hours to act: top up the cash, sell shares at the bottom, or provide extra security. Do nothing and the lender sells for you, locking in the loss at the worst price of the cycle. The 2008-09 crisis added the second trap: lenders cut approved ratios overnight, which triggered calls on portfolios that had not moved at all.

The interest is the third mechanism, and it compounds against you. At 8 percent on $50,000, the loan costs $4,000 a year whether the market rises or falls, and the interest is charged monthly. The deduction helps when the borrowing genuinely buys income-producing assets: at a 32 percent marginal rate, $4,000 of interest against dividend income costs roughly $2,720 after tax. For the strategy to pay, the amplified return has to outrun the interest bill plus the risk of the call - and the interest never takes a year off. The drawdown risk calculator prices what a geared portfolio survives.

For an Australian reader, margin lending is the leveraged version of every investing decision on this site, and the amplification works in both directions with no exceptions. MoneySmart's guidance is blunt: margin loans are high-risk, the lender can change the terms, and the calls arrive exactly when selling is most expensive. ASIC regulates the products and requires lenders to warn about the risks. The 2008-09 experience is the case study: the margin lending book shrank by billions as lenders cut ratios and borrowers sold into falling markets to meet the calls. The interest is deductible like negative gearing on property, but the deduction is a discount on a cost, not a profit.

A colleague named Brent (yes, that Brent) geared his portfolio to the approved maximum in late 2007 because the market had risen for four straight years. The GFC took the market down by half and the approved ratio was cut overnight. The margin call forced him to sell at the bottom of the cycle. He locked in a loss the unlevered version of the same portfolio would have recovered from by 2010. The highest-leverage thing most Australians can do is keep the LVR well below the approved ratio - 30 against a 40 approved - hold a cash buffer for calls, and run the geared numbers through the investment calculator before borrowing a dollar.