Should you borrow money to bag a sharemarket bargain?
There’s a reason why one of Warren Buffett’s most famous advice—to be fearful when others are greedy, to be greedy when others are fearful—is currently experiencing a resurgence among investors.
With the stock market still under constant pressure, savvy investors are looking for an opportunity to bag themselves a bargain. But the problem for many is that this decline comes after years of cost-of-living pressures that have left people either unable to save or using up what savings they do have.
It’s little wonder, then, that there’s so much chatter about borrowing money to invest. One of the most common ways to do this, especially when the loan is used to invest in the market, is through something called a margin loan.
For those who don’t know, margin loans are similar to a car loan or home loan in that they’re a very specific type of loan that has strict rules about what the money can be spent on. For margin loans, this purpose is to purchase stocks, exchange-traded funds (ETFs), or managed funds.
On the surface, the basic math of borrowing money to invest seems pretty simple and appealing.
Let’s say you want to take out a loan of $50,000 and invest it in the stock market. With an average annual return of 9 to 12 percent and an average interest rate of 5.5 percent, you stand to walk away with a profit of 3.5 to 6.5 percent each year with little or no effort.
From all this, it may seem like I’m anti-margin loans but that’s not the case.
But in reality, when you read the fine print and dig deeper, it’s a little more complicated than that.
For starters, interest rates on margin loans tend to be higher than interest rates on standard loans, typically ranging from 7.5 to 10.5 percent. This is because these types of loans are inherently higher risk, and the primary collateral for the loan (the stocks and ETFs you invest in) is relatively volatile compared to more traditional loan securities.
Then there’s the loan-to-value ratio (LVR) and margin calls. To offset some of the risk, margin loans have strict LVR levels set by the lender, usually 70 percent.
As we all know, the stock market is like a rollercoaster. And although the smartest investors will tell you that the best skill you can have is to ride out the lows and remember that at some point the highs will come again, unfortunately this does not satisfy the lenders.
So when the market falls and the value of your portfolio exceeds a certain point, your LVR will automatically increase above the agreed percentage. In such a case, you will be issued a margin call.
When this happens, a lender will contact you and tell you that you need to find a solution quickly. Generally, when a margin call is made you only have 24 hours to ensure the LVR is reduced to the agreed rate.
The good news is that there are several ways to do this. The first option is to save some extra money and reduce the loan balance. The second option is to add more stocks and increase the balance of your portfolio, and the third is to sell part of your portfolio and thus reduce your loan balance.
But all three of these options have caveats. Contributing extra money is only possible if you have savings that are easily accessible and enough to cover the difference. The second depends on whether you have additional capital or investments you can contribute; And that’s not always something people have easy access to. In the third option, you sell your investments when they are worth less than their true potential value, or worse, when they have no value at all.
If the value of a stock decreases at a certain moment, it does not mean that it is no longer worthless. The monetary figure assigned to the share may increase or decrease, but as long as the number of shares you own remains the same, you haven’t actually lost anything. As an investor, selling at this low point is your last resort.
From all this, it may seem like I’m anti-margin loans but that’s not the case. They can work really well in many situations.
For example, let’s say the $50,000 mentioned earlier is currently sitting in an offset account, helping reduce the interest on your mortgage. Instead of using this money directly, you can take out a margin loan.
If the market crashes and the LVR drops below the pre-agreed rate, you already know you have savings on hand that can be used to top up your loan without leaving you in a blind panic.
Moreover, the return on interest in the early years will increase, even if it is minimal. Let’s say the return after interest is 3.5 percent per year. Thanks to the magic of compound interest, $50,000 will become $70,000 in 10 years. And that’s a solid investment portfolio that you now fully own and can hang onto for another decade or two.
Another advantage of margin loans is that the interest is tax deductible because the money is used to purchase income-producing assets. But the potential benefits of this really depend on your current tax bracket.
At the end of the day, like any other investment strategy, margin loans will be a great option for some people and not so much for others.
This is because, as boring as it may be to say, it is true that there is no one-size-fits-all strategy when it comes to building your future. It’s about deciding whether something is right for you and what you want, and finding the balance between what you can reasonably manage.
While Warren Buffett is right to advise you to be greedy when others are fearful, I think what he forgets to say is that greed should be driven by a clear understanding of the market and your goals, never driven solely by fear.
Victoria Devine is an award-winning retired financial advisor, bestselling author and host of Australia’s #1 finance podcast. He’s after the money. He is also the founder and director of Zella Money.
- The advice given in this article is general in nature and is not intended to influence readers’ decisions about investments or financial products. They should always seek their own professional advice, taking into account their personal circumstances, before making any financial decisions.
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Victoria Devine is an award-winning retired financial advisor, best-selling author and host of Australia’s number one finance podcast, She’s on the Money. Victoria is also the founder and managing director of Zella Money.
