The rich rule over the poor and the borrower is the servant to the lender!
Borrowing money to invest in shares is not for the faint hearted.
While it may seem a smart way to build a share portfolio, using someone else's money to invest, or margin lending, has its pitfalls for the unwary.
And, if you don't have a healthy stable income, or you are heavily in debt elsewhere, it is one area which you should not even try to understand.
That is because margin lending, like any investment which offers high returns, carries high risks.
Investors are drawn to it because there is the chance of multiplying any sharemarket rises and increasing diversification.
Investors need to be wary because not only could the value of their investment deteriorate, but also because their obligation to maintain the loan level increases if the sharemarket takes a tumble.
Using someone else's money to make profits is a great idea but if those investments incur losses, the problems compound!
What Is Margin Lending?
Margin lending involves borrowing money against shares you own - in order to purchase more shares. In effect it enables you to build a portfolio where, depending on your specifications and the financial institution, your borrowing level can range between 30 - 80 per cent of the portfolio's value.
Once the investor specifies how much of the portfolio they want to leverage, a loan level is set to buy shares up to that leverage level, and interest is payable on that sum. Financial institutions set minimum loan levels for margin lending.
Of course the more money you have invested, the more you stand to gain if shares in your portfolio go up in value.
Any rise in the value of your portfolio also means that your leverage level goes down, giving you the capacity to borrow even more, using the increased value of your shares as security.
Another plus of margin lending, is by having more money to invest in shares, you can afford to diversify more - reducing your downside risk.
The danger, just like the attractiveness of this investment, is sharemarket volatility. If the sharemarket falls, not only will the capital value of your shares drop, but you could be forced to maintain the level of security for the loan if your gearing level breaches a preset level.
This is known as a margin call, and would involve an up-front cash payment, a sell-off of shares at a loss, or the purchase of additional shares ( if you have the luxury of spare cash).
A margin call usually has to be met within 24 hours. In the event the investor can't be contacted, the broker has the right to sell down the portfolio.
If your share portfolio is worth 75 percent of the loan and the sharemarket falls, you have to kick in more money to make sure that 75 percent is maintained.
In effect, any drop in the paper value of your investment increases your obligation to the lender.
For this reason, any margin lending investment needs to be constantly monitored.
Who Should and Shouldn't Invest?
If you are looking at this investment, you should fit into the following two categories:
A. Be liquid, in other words have access to cash and
B. Take a long term viewpoint!