Gearing through Margin Lending

Most people are comfortable with the idea of borrowing up to 100% in order to purchase their own home yet hesitate at the idea of borrowing money to start an investment gearing program. Gearing through a margin loan is a great way to create long-term wealth if an individual has the right attitude and psychology to implement this aggressive strategy.

A margin loan will increase and multiply profits because:

• with gearing there is more money invested than otherwise would be; and
• it is possible to benefit from tax concessions associated with gearing

But of course, if gains can be multiplied with margin lending then obviously losses can be too. This is why it is essential that anyone embarking on a gearing strategy has a long term outlook and the ability and means to stomach short term losses, which are a reality.

For the margin lending program to be successful over the long term, the investment portfolio created with the margin loan (or equity in the family home) must generate a total return (including both income and growth) that exceeds the after-tax cost of borrowing those funds (including interest).

With a margin loan, the investments purchased are used as security for the loan. Typically, an investor can receive up to 70% of the value of approved assets as a margin loan (and provide 30% of the total value) although this can differ across lenders and shares/unit trusts. This is know as lump-sum gearing as the investor provides an initial lump-sum.

For example, if an investor had $30,000 and she wanted to invest in an approved asset with the aid of a margin loan to gain greater exposure, then it will be possible to borrow up to $70,000, thus making a total investment of $100,000. Having said that, the investor need not borrow up to the maximum level and may elect to borrow only $30,000 to reduce the degree of leverage to 50%. The example below illustrates portfolio value at the end of 15 years after loan repayments and tax for an initial $30,000 contribution at various gearing levels.

The other type of gearing is known as instalment gearing. With instalment gearing after the initial lump-sum is provided, the investor can also provide regular instalments matched by the lender at the chosen leverage ratio. For example, the above investor could provide regular instalments of $300 per month with the lender providing $700 or 70%. Again, the investor can choose a lesser amount.