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Investor Education > Margin Lending > How does margin lending work?

HOW DOES MARGIN LENDING WORK?

The amount that you may borrow in a margin loan is dependent on the value of shares, managed funds, master trusts, wrap investments or cash you provide as security, as well as whether or not you meet the lender's lending criteria. The lender will then apply a maximum gearing ratio to shares and managed funds on their Acceptable Securities List. The formula used in calculating how much you may borrow is:
 

Security Value x Gearing Ratio = Total amount you can borrow
(1-Gearing Ratio)                                            

Using this formula, if you have a security with a value of $53,333 and the Gearing Ratio or Lending to Valuation Ration (LVR) is 60% then you can borrow $80,000.*
 
Margin loans are interest only loans and borrowers are able to capitalise interest up to the LVR. So an investor who borrows at a LVR of 50% on a portfolio with a 70% limit can allow interest to capitalise until the loan reaches the maximum LVR. To calculate how much you may be able to borrow. The interest on margin loans can generally be claimed as a tax deduction. Investors can prepay interest and bring forward tax deductions by paying 12 months' interest in advance. By making an interest payment in June for the next financial year, borrowers may then claim a deduction for the whole amount against taxable income in the current financial year.

Case study: Kim
Kim decides to borrow $100,000 to invest, and her marginal tax rate is 46.5%. Assuming an interest rate of 9.5% pa and 4% pa investment income (representing a cost differential of 5.5% per annum), then the net after-tax cost of borrowing is $2,557.50 in the first year, as the table below shows.

If Kim’s investment increases in value by 10% ($10,000) in the first year, she would now be $7,057.50 better off, after taking into account her $2,942.50 cash flow shortfall. In other words, the borrowed funds have earned her $7,057.50.
 

Kim's example (Source: St George Margin Lending)
Cost of $100,000 loan @ 9.5% $9,500
Investment income @ 4% $4,000
Pre-tax cash flow shortfall $5,500
Tax deduction @ 46.5% $2,557.50
After-tax cash flow shortfall $2,942.50
Net Profit $7,057.50

If Kim’s investment portfolio suffered a 10% fall, and then Kim’s loss, on paper, would be $10,000. When that is added to her $2,942.50 cash flow shortfall, Kim will be $12,942.50 worse off.

*Assumptions: borrowed funds are used to purchase investments. Those investments are provided as security. Investments have the same gearing ratio as existing security.

 

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