a home equity loan for anything
If a lender has a policy to only give you 50% of the value of an
investment, you'll have to invest one dollar of your own money for
each dollar they put in.
If you want to buy $50,000 worth of shares and you want to go to a
margin lender, they will expect you to put up the first $25,000.
A margin call may result if your portfolio falls below certain limits.
If your $50,000 share portfolio fell in value to $30,000, the lender
will become nervous and want you to repay part of the loan to
reestablish a conservative loan to value ratio, in this case they
might ask for another $10,000, so you'll only owe them $15,000, and
this is secured against the $30,000 share portfolio.
Not all lenders have margin calls as part of their standard policy, if
this is a concern to you you should shop around. In general though, if
you go with a lender that promises not to ask for margin calls there
will be a catch, like high interest and a very limited list of
pre-approved investments. I ran the numbers on a margin product from a
major Australian bank and found that the terms were pretty
extraordinary. Minimum $200,000 investment, you could invest only in a
basket of Australian blue chip stocks of their choosing, stocks like
BHP, National Australia Bank and Telstra. The interest rate was 18%pa
over 5 years. You just pay the interest and then the principle at the
end of the five years. You borrow $200,000, pay $180,000 in interest
payments over five years and give them back their $200,000, so you pay
them back a total of $380,000, if any share makes a loss they take the
share instead of the cash repayment. It is a pretty sweet deal for the
lender, worst case scenario is that over five years you pay them back
almost the full initial amount in interest payments and their biggest
downside loss is they could end up holding a bunch of blue chip
stocks. I would wonder though, if any investor has the slightest hope
of making any money out of this with such a high interest rate. A lot
of margin lenders offer terms like this. In this case the bank
couldn't lose, but for the investor it does look a bit harsh, I don't
think you can justify borrowing with a real interest rate above 10%.
Margin calls are a reality in most forms of gearing where you borrow.
If it is a managed fund the margin lender might be more generous with
their gearing ratio compared to a few direct shares, and they might
look more favourably on a situation where you want to borrow to buy a
few blue chip shares rather than less well known issues. In general
they will look more favourably on investments into well known
diversified trusts rather than boutique sector and specialist funds.
You'll have margin calls on investments into property trusts if the
value of the investment falls below the lender's guidelines, just as
you would with a share trust, but normally you don't get margin calls
with direct property investments, instead the lender will try to lend
conservatively to start with, insisting on a large deposit and/or an
independent property valuation and other guarantees before they give
the money.
Margin calls are awkward because they necessarily come at a bad time,
when the investment has fallen in value. You may be forced to pay the
margin call by selling assets, which would be a real pity if this
happened at the same moment as the market bottomed out.
Avoiding margin calls
I hate margin calls, they are a complete disaster for long term
investors, because the sudden demand for cash could come at an
inopportune moment and force you to sell at precisely the wrong time.
There are a variety of ways of avoiding a margin call:
First of all, you can use a home equity loan, with your home as the
collateral. This method is fine, and I think should be the first form
of credit you seek if you want to borrow to invest. You'll pay the
same interest rate as your home mortgage, which is pretty much the
lowest rate you will be able to get anywhere, and the only thing that
bothers the bank is your regularity of paying it off. You can then
invest in whatever you like and provided you are comfortably able to
repay your mortgage you will be fine.
You can use a home equity loan for anything, including holidays and
cars etc, so provided you have sufficient equity in your house you
will have nothing to fear from a margin call with this type of loan.
There are two other forms of loan that are not subject to margin
calls, but I'm not crazy about either of them. The first is basically
an unsecured loan, a standard personal loan from a bank or credit
union. The interest rates are very high and I don't recommend them,
but if you are that keen on gearing and can't use another form of loan
then it is your only real option.
The other form of non-margin loan you could use is a protected equity
product. These are the loans I briefly alluded to above, the one with
the huge minimum investment and high interest rates. Interest rates
are even higher than an unsecured loan (because the lender has to buy
put options to hedge your portfolio, because they offer a capital
guarantee on the investment). The interest expense above the usual
unsecured rate is regarded as a capital protection fee by the tax
office as opposed to a borrowing expense, so you can't claim all the
interest as a tax deduction, only the amount up to the unsecured
interest rate.
I've seen examples of them being used and in the literature they do
seem plausible to an extent, but the assumptions for growth are to my
mind a little bit optimistic and I am not entirely certain that
investors will make much money out of these, even with the tax
expenses. This sort of protected equity product is most suitable for
people with a very high income but no home. Personally I think the
interest rate is just too high and would recommend installment gearing
with a conservative loan to value ratio instead.
I just alluded to a conservative loan to value ratio. This is the last
point and it is a good way to avoid margin calls. It is quite simple
to do.
The lender may well be willing to lend 70% of the value of the
portfolio, but I don't think this is really all that flash an idea. If
you borrow 70% you have no margin at all to allow the market to
fluctuate (well, in practice they give you a little buffer, but I'm
choosing to ignore that).
Being prudent I like to invest with the implicit assumption that the
investment is going to lose 50% of its value, at least temporarily. If
you can avoid a margin call with a 50% fall then you are doing ok. How
do you do that? Well if you only borrow 35% of the value of a
portfolio from a margin lender you will have the required buffer (with
a 70% LVR margin loan) to endure a 50% fall.
Only 35%? That's not very much! Well fear not intrepid entrepreneur,
because the remaining funds don't necessarily have to come from your
bank account, you could use a home equity loan to come up with the
other 65%. So if you borrow $65,000 as a home equity loan, you can
then borrow another $35,000 from a margin lender and have a $100,000
portfolio and you won't have to worry about margin calls except in
really extreme circumstances. If you have a reasonably diversified
portfolio that includes a meaningful amount of diversification into
property trusts and various types of share investment you probably
won't have to fear a 50% drop, but as a doomsday scenario it makes
sense to me.
If you think 50% is unlikely and would prefer not to be such a sissy,
you might choose to assume a 30% drop instead (for a diversified
portfolio that is a pretty big drop!). If you want to build a
portfolio without fear of margin calls with a 30% drop you can set
your borrowings to 70%*70% = 49%.
By combining the different types of loan you can secure a reasonably
low interest rate (home equity loans have the lowest interest rate,
margin loans the next lowest) and also buffer yourself against margin
calls. We know from history that gearing is a good strategy (as
evidenced by the much higher rate of return of stocks and property
than cash investments) but we also know that borrowing is extremely
dangerous, ruining as many people as it made wealthy. The disasters
that have occurred in the past inevitably came because people got
greedy and used borrowing to excess.
If you can afford the interest payments (including a margin of safety)
and don't need to fire sale anything to meet margin calls you will be
in a much better position to benefit from gearing as a long term
investor, as opposed to having it turn around and bite you the way it
often does with less cautious investors.
Nicely balanced summary. Except you could have said up-front that the 18% interest
rate is in practice almost certainly a capital-protected loan.
Another suggestion: what one does with the interest repayments is an extremely
important issue, and there is a lot of flexibility out there. It can be capitalised,
periodic payments can be made, dividends can offset it, or one can choose to
participate in a dividend reinvestment plan but sell off a proportion of the
holding, etc.
And it might also be worth hammering out an obvious but often overlooked point:
anyone borrowing to buy real-estate is geared, with the level of gearing depending
upon the size of the deposit. It is comparatively easy to buy property on 95%
margin, with little danger of a "margin" call. You in general can't do that with
shares. This might be perceived as either a plus, or as a minus. Just some food for
thought ...