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Loading ...Is Topping up margin loans risky?
April 23, 2008 by Josie Kay
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Q. I’ve heard of people who have a margin loan being asked to top up their geared investment at a moments notice. Sounds risky?
Josie’s answer: If your investment loses money, not only is the loss magnified as well, but you still have to pay back the loan. With a margin loan, your lender will ask you to repay part of your loan or top up your account with some other security, such as other shares you may have. If you can’t do this, you might be forced to sell part of your investment.
It is all to do with the debt to equity ratio. If you keep this at a reasonable level, around 50% equity/50% debt, normally things are OK, but there are never any guarantees.
If you do get a margin call, you can lose quite a lot of money, as you’ll probably be selling in a falling market – if you’re really unlucky, fire-sale prices may apply. Therefore, it may not be a good strategy in times of high share market volatility, when margin calls are more likely.
Investors usually have a couple of options, they can sell off some of the investment or add their own funds. Following is an example supplied by Commsec:-JANE has $30,000 invested in Cochlear shares and would like to increase her shareholding to $100,000 with a margin loan.
As Cochlear has a 70 per cent loan-to-valuation ratio the most she can borrow on $100,000 worth of shares is $70,000, contributing her existing shares to make up the balance.Later, Cochlear’s share price falls by 10 per cent, taking the value of Jane’s holding to $90,000. Jane’s loan of $70,000 now represents an LVR of almost 78 per cent, which is above the 70 per cent maximum LVR plus a 5 per cent buffer she is allowed.As 70 per cent of $90,000 is $63,000, Jane is issued with a margin call of $7000 to make up the difference between this new maximum loan amount and the old loan.Jane has three options:* Pay back $7000 in cash.* Lodge additional shares as security.
If she has more shares with an LVR of 70 per cent she can restore her old gearing levels by lodging shares worth $10,000. However, if the LVR of additional stock is only 40 per cent she must lodge $17,500 worth of shares.* Sell shares to pay back into the loan. Jane would need to sell $23,350 worth of shares which would leave her with an investment worth $66,650 and a loan of $46,650 (70 per cent of $66,650).
Jane believes the fall in Cochlear’s price is likely to be short-term. As she has money in the bank, she stumps up the cash rather than sell her shares when prices are weak.Source: CommSec
Cashflow is king i.e. if you have income to support a loan that is great. Therefore, if your finances are under control, it can actually be a good thing to get a margin call as you are purchasing when the share or unit price is down (I am assuming you are invested in quality assets!)
This may sound a bit odd, but it is just like petrol prices. When we see the price of petrol per litre going down, we rush in to buy before the price goes up again. This is because we are going to buy more litres and, pardon the pun, drive your dollar further.
So if you do get a margin call, you are buying more shares or in the case of managed funds units because they are cheaper, so you are getting more for the same money. Hope this helps.
More stories about Margin Loans here:
Margin Lending – What is Your Exposure?
Margin loans
What are Margin Loans and do You Understand Them?
Margin loans and short selling explained
Don’t forget that the above information is general in nature and not specific to your goals and objectives. It is recommended that you seek personal financial advice specific to your needs. Also remember, that apathy can end up being your biggest expense!
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