## Portfolio Loans or Margin Loans

### For leveraging your financial potential?

Portfolio loans, or margin loans, are terms used to describe a loan for buying shares where your current portfolio provides the equity (financial backing) to support the loan. They represent one type of equity loan.

The purpose of a margin loan is to be able to enlarge your portfolio at a greater rate than what you would otherwise be able to do and hence leveraging profits if your investment strategies are successful.

It unfortunately also may mean that it magnifies your losses if your investment decisions are not sound, or if there is a major market downturn across the board.

Calculating the Lending Value of Your Portfolio

The benefit of portfolio loans is that the leveraging equity (financial backing) required is obtained from your current portfolio based on a Loan Valuation Ratio (LVR) applied to each share in the portfolio.

The LVR for each share depends on the lender’s view of the company’s financial soundness and may vary from 75% for ‘safe’ or large well-regarded companies down to 40% for smaller companies with a shorter operating history.

Quite a number of smaller companies with little operating history may not be given an LVR at all. Hence you cannot borrow against them.

In times of financial stress, think 2007-8, lenders reduced the LVR of companies perceived to be in financial difficulty. This put financial pressure on investors who over-geared.

As a simple example to show how to calculate the lending value (LV) of a portfolio, if you had shares in five companies whose current market prices were \$1,000 each, where two had a LVR of 70%, two had a LVR of 60% and one had an LVR of 50%, then the total lending value of the portfolio (\$3,000) would be calculated as follows:

Market Price(\$)LVR(%)Lending Value(\$)
Share A 100070700
Share B 100070700
Share C 100060600
Share D 100060600
Share E 100050500
Total LV =3,000

So for a portfolio amounting to \$5,000, an additional \$3,000 would be available to invest via margin lending.

Due to the net cost of margin-loan interest, after tax deductions, a higher portfolio return is required for the margin-lending strategy to break even. So it is important to have confidence in your share-investing ability.

What is a Margin Call

If there is a downturn in the market, portfolio loans may be subject to what is known as a margin call.

This means that either additional external funds would need to be provided to support the loan, or that some shares would need to be sold to provide the additional cash to support the loan.

By the way, if you get a margin call, you are required to do something about it quickly, commonly within 24 hours. Otherwise the lender will do something about it for you by selling off some of your shares to get you back within your new LVR.

Of course, having the lender sell off some of your shares after there has been a significant drop in the market is not a good idea from your point of view. So avoiding margin calls is always a good idea.

Lenders recommend to keep the loan to security ratio (gearing) of the portfolio below the maximum loan to security ratio allowed (usually about 70%) in order to provide a buffer to guard against a significant market downturn.

I keep the loan to security ratio (gearing) on my margin loan in the region of 20-40% when I have one in place.

Other Margin Lending Concerns

As well as the concern that a large drop in the stock market may trigger a margin call, there are related concerns that you should be aware of.

The first is that the lender (usually a bank) makes sure that it has a tight grip on your margin loan. It can reduce the loan valuation ratio (LVR) on any individual stock when it chooses to do so.

This might have the effect of tipping you into margin loan territory. This has happened during the recent global financial crisis.

As well, some banks that I have experience of, indicate in the fine print of the margin loan contract that they may recall the whole loan whenever they choose to do so.

However, even during the recent global financial crisis, I have not heard of an instance where a bank has done so. But ... buyer beware!

To Conclude

Always keep in mind that while portfolio loans can magnify profits, they can also magnify losses. This is why some advise against it.

Experience in riding a downturn is the best experience of all. As they say - no gain without pain! It is easy to develop a false belief that stock markets will keep rising – especially in an extended bull market.

But stock markets do not defy the law of gravity. What goes up can also come down!

Before considering portfolio loans or equity loans, investing experience in direct stock investing over a number of years (including one or two hefty market downturns) should be gained first.

This will develop confidence in your value investing ability and your ability to manage these inevitable events.

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