Borrowing, or gearing, can help you accelerate your wealth creation. It can allow you to buy assets such as an investment property, or shares that you may not be able to afford outright. However, borrowing to invest is considered a high risk strategy and can result in you losing more than your invested capital.
Before taking out a share investment loan, you should ensure that you can service the costs associated with the loan, including repayment of the loan principal.
You should also seek professional financial and tax advice regarding the potential risks and benefits of geared investing.
How does borrowing to invest in shares work?
You can take out a margin loan to invest in shares. A margin loan allows you to buy shares by paying only a fraction of the cost of the shares upfront, and the lender uses your shares as security for the loan.
The prices of shares move frequently and you risk losses if they fall in value. Lenders often express your level of gearing using a loan-to-value ratio (LVR) or gearing ratio. The LVR is the amount of your loan divided by the total value of your shares.
If the value of your shares falls to where LVR exceeds an approved maximum, you may be required to top-up your loan collateral or repay some of the loan.
This is known as a margin call. If a margin call is not met within a timeframe set by the lender, your shares may be sold by the lender to satisfy your margin obligations.
This may result in you suffering a loss.
How do I manage the risks associated with a margin loan?
There are a few strategies that can help you manage the risks associated with a margin loan:
- set a borrowing limit you are able to comfortably repay and stick to it
- make regular interest repayments on your loan to keep your loan balance within a manageable limi
- check your LVR regularly, because the value of your investments can change quickly
- have funds available to deposit if your lender makes a margin call and you do not wish to sell your shares
What are the benefits and risks of borrowing to invest?
You can build a larger portfolio than if you were using just your own funds.
Some lenders allow you to borrow using an existing share portfolio as collateral. This allows you to increase the size of your investment without having to deposit additional cash.
Manage concentration risk by diversifying your portfolio. For example, if your share portfolio is overweight in a certain sector and you do not want to sell the shares, you could use the equity in your current portfolio to borrow and invest in companies in other sectors.
Potential tax efficiencies associated with borrowing.
While a share investment loan can help accelerate the growth of your portfolio, it can also magnify losses if prices move against you and you can lose more than your invested capital
Interest costs associated with your loan may reduce your profits. Interest rates are also subject to change, and can result in an increase in the cost of servicing your loan.
LVRs, or margin rates, are subject to change at the lender’s discretion. This can lead to a requirement for you to deposit additional cash at short notice. In some cases, your shares can be sold by the lender to satisfy your margin obligations.
This can result in your shares being sold at a loss and you will still be required to repay the outstanding balance of the loan.
To find out whether gearing may be a suitable strategy for you, give our team a call. We can help you weigh up the pros and cons, to find a solution that works for your situation.
Source: Macquarie Group Limited