Methods

There are many different approaches to gearing, and a variety of products and facilities are available.

Most equity investment loans are set up on an 'interest only' basis, meaning that the only compulsory payments you make are to pay the interest due. You can repay the principal either at your own discretion along the way or at the end of the loan. This type of loan is suitable if you need funds to finance the initial purchase of the investment, and then plan to discharge the debt either out of cashflow or by realizing profits/capital gains.

The long-term goal is to eliminate the debt that you initially used as leverage. At the same time, you can keep your geared share portfolio as a discreet and separate facility from other loans such as your home loan.

Security

Unless you are providing cash and/or putting up separate assets as a security, you can use the investments you are buying as security for the loan. The lender will usually provide a specific list of shares and managed share funds that it will accept as security.

With margin lending, these approved securities will have a percentage allocated to them, which represents the maximum amount that the lender is prepared to advance against that security. This is usually between 40% and 70% of the market price of the security, and is based on the lender's view of the security's quality and volatility of the share price.

Margin lending

A margin loan allows you to borrow money against shares or managed share funds you already own, as well as enabling you to buy more shares, which form part of the security. A margin loan can be a powerful wealth creation tool, allowing you access to more shares than would be possible under normal circumstances. It effectively provides you with a flexible line of credit.

The shares or managed share funds are usually the only security required. If you are active in buying and selling investments, settlement for each trade can be made by debiting or crediting your margin lending account - provided that the loan balance remains within the limits agreed to at the start of the plan.

The main difference between a margin loan and a conventional property loan is that shares change in value each day. This means you can check the daily market value of your investments, and the lender will also monitor your portfolio value daily. If the value falls below an agreed minimum, the lender will require you to make a margin call.

Margin calls

A margin call will be made if your equity - the value of the assets that you contributed to the investment - falls below the agreed lending ratio. If this happens, the lender will ask you to provide additional funds to restore at least the minimum equity position. To help protect against small market fluctuations, there is usually a "buffer" (typically 5% of the total portfolio value) within which a margin call will not be made.

A margin call requires prompt action (usually before 2 pm on the next business day) so it is important to plan what you would do if you were faced with one.

There are a number of ways you can satisfy a margin call. You can:

•  Provide cash to reduce your loan balance
•  Provide additional shares as security
•  Sell shares from your portfolio and use the proceeds to reduce the loan

If you do not initiate one of these actions, the lender will act on your behalf, usually selling shares to reduce the loan.

The best way to avoid margin calls is to be conservative in the amount you borrow.

The table below shows how far a portfolio must fall in value before you would face a margin call, assuming various borrowing levels and given different maximum approved borrowing levels.

So using the table on this page, for a conservative investor with an actual borrowing level of 50% to invest in a blue chip portfolio (on which the maximum approved borrowing level would be 70%), there would need to be a 33% fall in the portfolio's value before a margin call would be made.

You can also reduce the likelihood of a margin call by:

•  Diversifying your investments
•  Making interest payments regularly
•  Reinvesting dividends to reduce your loan as a proportion of your total portfolio
•  Monitoring your investments closely
•  Sticking to your plan.

How much the market needs to fall for a margin call to be made

*Assume that the lender allows a buffer of 5%

Borrowing by instalments

Instalment gearing is a margin lending facility which incorporates a regular savings option.

Investment is restricted to managed share funds, which allow investments to be made in relatively small parcels. The initial investment can be as low as $1,000 and regular investments as little as $250 per month.

Every contribution you make is matched by borrowed funds, so instalment gearing can be a convenient way of accumulating geared investments. The idea is to have a regular, automated facility in which you save, borrow and invest each month so that you gradually increase your total investment.

Dollar cost averaging

One advantage of regular investing is that, if the price of what you are buying fluctuates, you can reduce the average cost of your investment. By investing the same amount each month, you buy more units in the share fund when the price is low. This is known as dollar cost averaging. It doesn't guarantee you a profit, but it does offer a relatively low-risk way of investing in a volatile market.

Home equity loans

There are gearing products available that allow you to unlock the equity you have built up in your home and use it to help finance new investments. The aim of the facility is to pay off your home loan faster while allowing you to build wealth at the same time.

This type of loan, is in effect, a line of credit secured against the asset value of your property. You may have paid off your mortgage completely, in which case the full amount of the loan facility is available for investment, or you may still owe money on your home, in which case the facility can be split into two components.

Home equity loans are highly flexible. Within one facility, for example, you might have a variable rate housing loan into which you direct your salary, coupled with an investment account from which you 'draw down' for investment purposes. With all the borrowings at home loan interest rates, this is a very cost-effective way of gearing.

It is also a highly tax-effective strategy, because usually you are directing your salary towards paying off a housing loan on which the interest is not deductible, while freeing funds for investment where the interest cost is deductible. Any extra income from your investment can be used to repay your home mortgage even faster.

Protected Loans

Protected loans enable you to benefit from sharemarket growth without the risk of losing any capital - an ideal way to get started in the sharemarket. The lender provides 100% of the funds to invest in quality Australian shares and these shares are the only security required for the loan.

Protected loans usually attract a higher interest rate than other gearing facilities - similar to credit card rates, but the bonus is that you are protected from a fall in value of any shares held under the facility. This means that if at the end of your loan term some of your shares have fallen below their original value, you can return those shares to the lender in full repayment of that portion of the loan. On the other hand, you can take the profit from any shares that have risen in value. In addition, profits are not nettled against losses, so you ignore any losses, whilst the profits are yours. Best of all there are no margin calls.

Protected loans typically involve buying and holding your share portfolio for the full term of the loan, usually 3 to 5 years. They can be useful in insulating you against a correction in the sharemarket and for this reason protected loans often attract a more risk conscious investor than say margin lending.

Reproduced with the kind permission of Macquarie Margin Lending

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