Gearing Strategies - Margin Lending
Borrowing to invest is a common strategy aimed at increasing the amount you are investing into an investment and in many cases improving the tax efficiency of the investment.
This is because Australian tax law allows you to claim a tax deduction for the interest paid on money borrowed to make the investment. You can also claim other costs associated with the management and maintenance of the investment.
There are many ways to borrow to make an investment. In terms of a property investment, the most common way is to borrow from the bank. The bank will then grant you a mortgage using the property as security. The amount they lend to you will depend upon the size of the loan you are seeking and other security that is being offered. The type of loan you take will depend upon how tax effective you wish the mortgage to be as an interest only loan is more tax effective than a principal and interest (P&I) loan but a P&I loan is more wealth effective in the long term.
In terms of borrowing to invest in shares and managed funds, the most common way is to use a margin loan. Some people use a line of credit secured by another asset, such as their principal place of residence
Margin Loans
Margin loans are provided to investors as a percentage of the market value of the investments nominated by the investor and approved by the financial institution. The difference between the market value of the investments and the amount of the loan is the margin. The investor must contribute the margin.
A typical margin lending facility would operate as follows:
- Amount of Loan - The maximum amount that can be borrowed is dependent on the current valuation and quality of the underlying investments. Generally a loan to valuation ratio of 75% is the maximum. For example, with your initial investment of $60,000 you could take out a margin loan for $140,000 as this would represent a 70% loan (140,000) to valuation ($200,000) ratio.
- Term of the Loan - There is generally no fixed term and they continue indefinitely.
- Interest Rate - Both a variable and fixed term rates are generally available
- Security - The lender takes a mortgage over the investments and in most cases the lender will require the investments to be registered in the lender's name.
- Credit Assessment - As the lender has security over the loan, the lender does not require the investor to provide it with detailed information about the investor's financial position prior to the commencement of the loan.
Margin Calls
Once in place you are required to ensure the loan does not exceed the maximum loan to valuation ratio (LVR). If the loan margin ratio exceeds the agreed upon limit, then you will be faced with a margin call.
For example, if the loan was $140,000 and the portfolio at $200,000 you would have a LVR of 70%. If the portfolio fell in value to $180,000, then the LVR would rise to about 78%. A margin call would then be invoked and you would need to contribute additional funds or sell some of the investments to return to the maximum allowed LVR.
Margin lenders usually require the LVR to be restored to the agreed limits within a stated time period, generally within 24 hours. By borrowing less than the maximum loan limit, you can minimise the risk of a margin call.
Tax Implications for your Investments
Income and capital gains on your investments will be included in your assessable income.
The underlying portfolio is predominantly exposed to Australian Shares and these investments give rise to imputation credits which reduce the tax you pay.
I have included information in the Supporting Material section to explain Capital Gains Tax and the Dividend Imputation system.
Tax Implications of Gearing
Gearing is a tax effective strategy which usually helps to reduce the tax you pay each year. The interest on the margin loan is tax deductible and can be used to offset tax payable on your other assessable income. If the interest is greater than the income you receive your taxable income will be reduced. This is commonly referred to as “Negative Gearing”. This means that the true benefit of gearing is only realised when the investor is in the top two tax brackets.
As the value of the investment increases in value, the portfolio will eventually become ‘positively geared’, meaning that the income generated is more than the interest payable on the loan. When this happens, tax will become payable on the income amount in excess of the deductible interest on your loan.
In addition to interest costs, other borrowing expenses such as fees, legal expenses, stamp duty and broker’s commission are deductible over the life of the loan, or five years, whichever is the shorter period, beginning in the year in which the expenses were incurred.
Asset Allocation and Risk Profile
Gearing is only effective where the after tax return on investments is greater than the after tax cost of borrowing. This means a geared portfolio should have an asset allocation of at least 70% growth assets and is only suitable for investors who have a Balanced, Growth or High Growth profile.
Risks associated with gearing
While Gearing can be an effective means of increasing returns on your investment, it increases volatility in your account and increases the size of any negative returns. If the value of the investments fall, both the initial capital and borrowed funds will lose value but you will still have to repay the full value of the loan.
For example, if a portfolio with $50,000 (with no gearing) falls in value by 10% you will lose $5,000. In the same conditions, a portfolio with $100,000 (with $50,000 gearing) will lose $10,000. With the full $50,000 to be repaid on the loan, the actual loss becomes 20% as the original portfolio value of $50,000 is reduced by $10,000 to $40,000. So, whilst gearing can boost your returns, it can also magnify your losses.
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