Do You Understand Margin Loans?

There has been a lot of media coverage on "Margin Loans of late and a lot of it has been very negative.Even Ceo's and Company Directors have encountered problems with the use of them.Because of the huge amounts they borrowed on margin. This can work out to either big profits or in their case big losses involving millions of dollars.

Basically speaking what is a Margin Loan? Put quite simply you are borrowing money to invest in shares or managed funds.. But the major difference from an ordinary loan is that you are not borrowing the whole amount.You are only borrowing a percentage of the total amount. Here is a scenario and some figures to simplify things.

Firstly to make things easier we shall assume that the total loan amount is a nice round figure of $100,000.With this margin loan you only have had to put in around $30,000 yourself. (This can vary depending on your lender.). But you have the whole $100,000 to invest. The difference in this case obviously being $70,000.

The difference between those two sums is called the "Loan to Value Ratio" or LVR. This percentage is adaptable depending on the quality of the shares involved. Usually the better quality of the shares the higher the LVR can be .This is predetermined when the loan is first taken out.

Now the LVR plays an integral factor throughout the life of the margin loan. Because on what the percentage of the LVR is currently, will determine whether you have to put in more funds in or not.

For instance if the share price has dropped by 15% (As we have experienced recently in the stock market.)that $70,000 has now become $85,000, You will now get what is termed a "Margin Call."

What this means is as you are only allowed to borrow a maximum of 70% against the value of the share it means that you have to reduce the outstanding amount down to $50,500 ($85,000 x 70%) In other words you have to put in $10,500 out of your own pocket. This effectively brings the LVR back to 70% ($70,000 - $10,500+$50,500)

The hardest part is that if you experience a margin call is that it has to be paid within 24 to 48 hours. If you don't then your borrower can legally, and will sell off all or part of your share portfolio (At the current market price, which could mean a loss of 15% straight away) to cover the difference. Not a nice thing to happen to any investor.

But there are a few options listed below which are available to you in the eventuality of you getting a margin call.

1. Deposit the amount of cash required to immediately bring the LVR back to its original value.

2. Provide additional shares or managed funds as collateral to increase the value of your share portfolio.

3. Sell shares to raise the amount of cash required. This is the least desirable option as you are crystallising your losses immediately.

4. Have a "Line of Credit" already in place to cover you just in case of emergencies such as a margin call occurs.(I personally prefer this option.)

It is vital that you do your homework first and go through a reputable lender. The most popular and largest margin lender in Australia is Commsec. There you can have a choice of around 900 shares and 1300 managed funds.

Don't be blinded by "Greed" go in with your eyes wide open, Have cash ready or available in the case of a margin call or calls. Profits can be big, but in the type of market fluctuations that we are seeing of late, losses are very common and prevalent. As we have seen in the news lately.