Margin loan for a student

Hi guys I posted this on the Under 30 thread and didn't get a response so thought I'd try here.
My situation:

22 and final year of studies, living at home currently. Casual jobs but so far this year saved about $500/month.

I'm planning to go travelling for a fair chunk of next year so most of my $20K savings is going on that.

My plan is long term so I've been co-contributing to my super and expect to be working maybe late 2010/2011.

Assets:

$20K in high savings a/c

502 AMP shares, a bit from demutalisation and SPP to try to dollar cost out

$10K in Macquarie Flexible Investment Managed Growth Fund MAQ0014AU
dollar cost averaging and reinvesting dividends since Nov. 08 now worth $11420. I'm pretty happy with that performance, how does it measure up?


My questions:

1. I see a lot of people invest in different funds across sectors. Is this common and isn't the fees high?

2. Margin lending: I'm looking at gearing to a 50% LVR and capitalising the interest. How sustainable/recommended is this with the lack of a regular income? (If lenders will even approve me). Again I'm familiar with the concept of capitalising but probably not detailed enough.

Like I said I'm not too concerned with the short/medium volatility and am looking at 7+ years time frame. Is my financial position recommended for a margin loan? For me I just think the way the market is going it would be a great opportunity to get in now.

Thanks!

I have no experience with margin loans, but I expect my bank manager would want some proof that you could service your loan. This would have to be reliable excess income sepparate from distributions. Gone are the days when banks would showel cash to anybody.

People have multiple funds because A). they have the money and B). it evens out the returns. 7%, 8.6%, 6.2%, 4% averages to 6.45%. If you put all your cash in the 4% fund you'd be sad. And C). Asset allocation ei. Cash, Fixed interest, Bonds, Oz shares, foreign shares, property. By choosing funds that perform differently than one another (one up while the other is down), the level of risk is lowered.


Cheers Johny.

Margin loans have traditionally been an "asset lend" - meaning if you have the assets (existing shares or cash) to put in as collateral, they will loan you the money ... no need to prove income.

I know ASIC wants this to change to include servicability checks, but I don't think it necessarily should. People just need to understand how margin lending works - it is not the same as a house loan, and margin loans should not be considered as "consumer" products in my opinion. As such, they are also not suitable for most investors (who simply don't understand how to manage the risk associated with those products).

With regards to managed funds - don't get hung up on fees ... a product which consistently returns higher than another product is probably worth paying more for. The only question then is - can it continue to outperform the cheaper product over the long term (how is your crystal ball working?)

Nice thanks guys. How does one go about getting one? Through a broker like Commsec like you do with managed funds?

And I'm a beginner with investing and finance took a general education class on it and the lecturer got me hooked on it. He also talked about capitalising the interest and from what I understood you roll the interest back into the loan? Sim I read your guide to margin loans and couldn't find anything about it? Can you point me in the right direction?

Also as a aside, at the amount of money I have invested is it worth borrowing more or would the interest negate it?

Sorry for all the newbie questions!

Cheers

InfoChoice has a page listing all the margin lenders in Australia:

Investments from Infochoice - compare features and interest rates

Just go to the various websites and check out their products and interest rates.

Don't forget to compare the LVR tables for the shares/funds you have or intend to buy, even if you don't intend to gear up to the maximum they will allow - a larger maximum LVR gives you a bigger buffer to play with when the market drops.

Capitalising interest is simply borrowing money (ie drawing down on the available equity in your margin loan) to pay the monthly interest costs. In reality what happens is that each month your outstanding loan amount goes up by the amount of interest you have been charged.

Just be aware that capitalised interest is a compounding effect (you end up paying interest on the interest), so if your portfolio isn't growing or you don't add extra capital to maintain your loan balance, it will continue to grow at an increasingly fast rate - and your LVR may rise to the point where you face a margin call. Capitalising interest requires careful maintenance of your LVR.

Whether you should borrow more depends on a lot of factors - not something we could advise on. Just remember that if your investment is not returning at least as much as what your interest costs are, then borrowing to invest is actually costing you money!

To put it another way, if you are paying 8.5% interest on your margin loan, then you need to be earning at least this much (total return: capital growth + income) to make the investment worthwhile. In general you would want to be making even more than this to justify the risk you are taking on - some people insist on at least a 2% "risk margin" - meaning that in this example your investment would need to be returning at least 10.5%pa on average to justify the gearing costs.

I think Sim is very nicely trying to say don't get too take too much risk too early... borrowing money to invest/speculate is risky business, and it's a very risky way to start your investing carerr.

Whilst many have made good money over the last decade through margin lending. Over the last 12 - 18 months there have been just as many who have been burned by the very sword that made them fabulously weathly (read into the Storm Financial collapse before thinking margin lending is an awesome idea).

It was only 12 - 18 months ago I was sizing up margin loans thinking that leverage was the road to riches... I have done almost a complete 180 on that belief now that I feel that I understand things a lot better.

Actually I am a firm believer that leverage IS the road to riches (one of the only roads other than "business" actually). However, as you have quite rightly pointed out the whole "leverage magnifies losses as well as gains" maxim is not really understood (or at least not really taken to heart) by most people who let greed take over when they start to see the gains.

My feeling is that for any geared investment in a volatile market - you MUST de-leverage when the market direction turns bearish (ie macro-level movement to a downtrend). Naturally there are ramifications of doing this (realised capital gains, potential mis-timing, transaction costs, etc) - but the costs of trying to hold a leveraged position through a bear market is potentially far higher.

Margin lending is not (in my opinion) a suitable product for the average consumer to use, since they are not likely to really understand it. I also don't think financial planners should be recommending margin loans to most of their clients, unless the planner is actively managing the entire portfolio (including lending) and has a sound strategy for dealing with bear markets.

I guess what I'm trying to say is - there is a time to leverage, and there is a time to de-leverage. Buy-and-hold using leverage is a dangerous game in my opinion.

Sim,

Interesting insight ... what are your thoughts on leveraging property through a bear market (given that the buy/sell costs are generally more significant?).

Jason

Generally, real estate is not subject to the same risks as margin loans - only in the worst case scenarios would you find banks calling in their loans.

The reasons for this are fairly simple: margin loans are asset lends, most real estate loans aren't and require you to prove servicability before you borrow.

The only protection the margin lender has is the value of the assets they hold as collateral on the loan. As the value of those assets moves up and down, the maximum value of the loan they will provide also moves up and down. If the value of the assets drops below a pre-determined level, they act to restore their risk margin by asking the borrower for more assets or to pay down the loan (ie a margin call). If the borrowed cannot meet this request, the lender reserves the right to sell down some or all of a portfolio to reduce the outstanding loan and restore their risk margin. A margin loan is effectively a revolving line of credit which theoretically never expires.

Lending on real estate is typically secured via first mortgage over the property and operates for a fixed term where the lender can expect to get their money back over a set period of time (assuming no refinances). Before a lender will loan money on real estate, they want to be sure that the borrower can afford to pay off the loan to the point that the bank gets all of their money back at the end of the loan period.

The trick with real estate is that it is not a liquid market like (most) shares are - the only true valuation is what someone is willing to pay for it on the day it is sold. If nobody wants to buy it (or nobody can afford to buy it), then the value is really somewhat less than what the owner/vendor believes it to be. Similarly, if there is sufficient interest in the property, the final sale may be much higher than anticipated. Any valuation done by a valuer when the property is not on the market is a guess at best.

As such, properties cannot be revalued on a daily basis like shares can. You typically wouldn't know if the overall market in that area has dropped for a period of months, and even then, it is a statistical measure based on sales of other properties, not yours.

At the end of the day, if you are able to make your repayments - the lender shouldn't care that much what the day-to-day movements of the real estate market are, since they are still getting their money back and earning interest.

Real estate bear markets come and go - typically they are not that dramatic and there is usually plenty of equity in a property so the lender isn't that worried.

If the market were to drop by 20%+ and properties were having difficulty selling, then the lender may start to get nervous, but it is rare in Australia to have a lender call in a loan where repayments are being met on time.

As you mentioned, the transaction costs of buying and selling real estate are so high that you generally don't want to be trading them (unless you are in the business of doing so - but that's a completely different ball game). I think that unless you truely believe that the real estate market is going to drop by a significant amount and that you may struggle to meet your repayments, then you should hold onto your real estate, even in a bear market. Real estate is generally a long term investment and the indicators showing market movements are generally too slow to act on in a timely manner, so timing the market is difficult - far more so than with shares.

Of course, you should be examining your entire investment portfolio at least annually and assessing whether the assets you hold still have a place in your portfolio.

I've recently sold some of my property to free up some capital for other projects and will possibly sell some more soon for the same reason (and also because the age and nature of the property means that it is becoming a maintenance nightmare), but I will be keeping other properties in my portfolio regardless of what the real estate market does.

I suppose when you really look at it, going into business is also a higher risk, leveraged investment - except your leverage is via your employees.


I agree that most people don't really grip that leverage/debt is a double edged sword precisely because leverage has been such an amazing tool for wealth creation for people over the last couple of decades.

In my opinion, the MASSIVE assumption this statement makes is that individuals are both equipped and capable of making such calls. Obviously some investors are well equipped but they aren't the majority.

I think for the vast majority of everyday workers, whose profession doesn't involve investing, are going to be very unlikely to make good quality decisions in regards to market timing or even company selection. Even very educated individual get the timing wrong all the time.

I wholeheartedly agree that it's not suitable for average consumers, but not because they don't understand it, but because they aren't equipped or experienced enough to utilise it or time the market.

LOL you're starting to sound like a trader!

But I agree, if you're not going to get hawkish about your investments (ie watch, study and actively participate in the markets) then leverage is not going to increase returns, it just makes your investment a gamble.

At the end of the day, I don't think it matters whether your investment is in real estate, shares, business etc if you are good at what you do (as in well above the average) then leverage is a great tool to increase returns. However on the flip side, if you are just your average investor in the long run excessive leverage may hinder more than help as well greatly add to the level of risk.