Margin loans: powerful tool or dangerous trap?

0:01Speaker 1:Welcome to How Do They Afford That, the podcast that peaks into the financial lives of everyday Australians. I'm Michael Thompson. I'm an author and the co host of the business news podcast Fear and Greed, And as always I'm with financial planner Canna Campbell, the founder of the financial literacy platform Sugar Mama TV, and my co author on our upcoming book, Twelve Months to Financial Freedom. It is out on the first of September. Hello, Canna, good morning, how are you. Oh? You know what, I'm a little bit wary about today's episode. Why because it is a topic that can be controversial, right, Okay, so you're with me so far. We are talking about one of the more controversial tools in investing. I would say margin loans.

0:54Speaker 2:So I would say we fear what we don't understand. That is as controversial.

0:58Speaker 1:Okay, all right, that's probably also fair. Some investors swear by them, others won't go near them. So today I ask you, margin loans a powerful wealth building tool or a dangerous trap?

1:20Speaker 2:I am bring it on because let's just we're going to diffuse any fears were people are going to have a very informed, educated opinion after this episode as to whether margin loan is powerful or whether it's a dangerous trap and tool, and whether it's maybe right or wrong for them or perhaps something they can consider for the down track.

1:40Speaker 1:Indeed, so, and of course, as you're listening to this today, know that everything that we're talking about is general in nature. It is never personal, investment, strategic or product advice. It is purely for financial education purposes only. You need to see a financial planner to get advice tailored to your circumstances. If you listening to this and going, oh, this is something I'd like to explore, talk to a professional and get some advice, let's start with the basics. What is a margin loan? Isn't a dangerous trap? No? No, I just tell us the margin loan bit and then leave the restport till later.

2:16Speaker 2:No, it's a very powerful tool. It is a risky tool, but when it's used for the right reasons and the right time, the right goals, it can be powerful. So essentially, it is a loan that you borrow, well, sorry, amount of money that you borrow obviously through a loan that's secured against existing investments. So say, for example, I have fifty thousand dollars worth of shares, and I really want to grow my portfolio, and I want to start being a bit more savvy and strategic in building my wealth.

2:42Speaker 2:I would go to a margin loan provider, normally through the online share trading accounts, and apply, for example, for a fifty thousand dollars margin loan, and I would assume it's approved. I would have fifty thousand dollars to go and buy fifty thousand dollars worth of shares. So now my portfolio is worth one hundred thousand doors from a gross value point of view. Obviously the net position is still fifty because I've got a fifty thousand dollars loan, and I would just take that out and invest it for long term growth opportunities.

3:09Speaker 1:And so the initial value of your portfolio was fifty thousand dollars, and so you have borrowed that full amount again, Yes, okay, all right, A lot of questions coming off that for me. But why would someone use one Lots.

3:28Speaker 2:Of reasons, but predominantly to be more efficient in building wealth and creating wealth? Obviously, you know you're borrowing money at a cost and expense to then try and get that money to grow at a faster rate than what you're paying. It's also a great tool for diversification. For example, I have had situations where clients had impressive in portfolios, but it was mainly held in one particular stock or just a couple of stocks, you know. Particularly was very common with employee share plans where they can't actually sell the stock necessarily because it's part of their contract. So this was a way of actually allowing us, you know, if they didn't have the cash foil the cashflow was going elsewhere, to use the shares that they already owned as equity to borrow money and then go and invest in other assets to help diversify the portfolio and reduce risk, as well as help and support their financial goals and risk profile. And then of course tax because the interest of your tax, the interest of your tax, the interest of your margin loan typically is tax deductible, So you would never make a decision like this purely for the

4:33Speaker 2:tax savings, but it definitely is an added advantage in this type of strategy, and it's secured against the investments inside the portfolio, so there is that I guess, additional protection. Some people don't they Even if they have a home and they are able to get recycle, they don't want to put their home security. They would rather quarantine it through a margin loan. And I have done it.

4:55Speaker 1:I've used a margin loan before.

4:56Speaker 2:I've used it a couple of times actually in my life.

4:59Speaker 1:Okay, let's do the maths a little bit. What's the upside here? Then if things go well, if the market is going reasonably well over a long period of time.

5:10Speaker 2:So the pendulum swings both ways with loverage, so it's obviously going to amplify what's going on. So say, for example, you know fifty thousand dollars of my shares, did I go and borrow fifty thousand dollars through marginalan, We've go one hundred thousand dollars invested. The market moves up ten percent, so now my portfolio is worth one hundred and ten thousand, whereas if I had not taken out that marginalone, my portfolio is worth fifty five thousand. So you can see, you know, obviously you've got playing with larger amounts, obviously bigger financial compounding growth opportunities. But as the pendulum swings the other way, you're magnifying the losses. So fifty thousand of my own shares fifty thousand borrowed market cut corrects ten percent. That portfolio is worth ninety thousand dollars. But I still have that fifty thousand dollars loan.

6:00Speaker 1:Okay, two questions Off the back of that. I'm learning a lot out of this so far, but I want to ask you about cash flow for one thing, and the importance of having cash flow to make sure that you are able to service what is alone. But before we get to that, can you explain a margin call in plain English?

6:24Speaker 2:So a margin call is where your portfolio from the gross worth point of view, drops below a certain level. And when you've got to apply for a margin one, you can see the thresholds that they have and it is very reflective as to the quality of the investments inside your portfolio, or how volatile they are, the types of companies you know, how well diversified your portfolios. You know, things like ETFs help reduce that risk quite significantly. But when it hits a certain threshold, and they'll give you warnings, you know, they'll call you or message you, they'll email you, they'll do smoke signals send doves like that. It's their responsibility to let you know that you're getting into this margin call a danger zone. But what happens is the portfolio has now dropped below a certain level that makes the lender uncomfortable and nervous that they've got, say a you know, in our situation, say one hundred thousand dollars worth of shares initially bought fifty thousand dollars alone. Say the market has a massive correction and drops, you know, from one hundred thousand dollars to say sixty thousand, that

7:21Speaker 2:might trigger a margin call because all of a sudden, that fifty thousand dollars alone is looking a little more dangerous as the portfolio continues to drop in value. So they will call you, email you, message you. And you've got a couple of different options. So when you get hit with a margin call, you need to either put some money towards that loan, or you need to add transfer some shares that you might have elsewhere, so you might have another online share trading account attached to a different HIN number you might roll them across. Or worst case, the margin lend provider will actually go and sell some down some of your shares in this situation with a very dramatic example, you know, that'd sell down the share portfolio and you'd walk away with just ten thousand dollars left over after they've taken back at they're fifty thousand dollars alone. Okay, so it is it is risky, but those risks are actually quite manageable.

8:12Speaker 1:Okay, How how do you manage those? Is it about having cash flow? About keeping cash and reserved to pay if this situation does come up so that you avoid having to liquidate shares and crystallize a loss.

8:25Speaker 2:So there's probably about seven or eight different things you can do, and I actually have a podcast on Sugarmum's Fireplay dedicated purely to all the different things you can do, and I would recommend you do all of these. But you know number one is don't borrow too aggressively. There's lots of data to show that even with the biggest market corrections, you know, example the GFC even which is when a lot of these margin calls got triggered, if yourfolio was not to was geared at a very conservative level, not exceeding fifty percent, you never got hit with a margin call. Getting hit with a margin call and having to sell is the worst outcome possible. So if you were in this zone, you wouldn't have actually got a margin call. Where people did during the GFC get caught out is because they had really aggressive gearing levels around sort of eighty ninety ninety five percent, which is just absolutely ridiculous and I think it's just irresponsible lending. That means they borrowed so aggressively, So they borrowed huge multiples of what they had in their investment portfolio. All right, so you want to don't borrow more than you can afford.

9:27Speaker 2:The other thing is to make sure your portfolio is probably diversified so that when market volatively hits you, you've put yours in a variety of different baskets to help smooth out that volatility. The other thing is obviously always having emergency money set aside. Now we've spoken about emergency money how important it is, but it's not a generic number or a formula. It's reflective of your situation. Okay, and again we talk about this in detail in our book Twelve Months to Financial Freedom. So that definitely what you want to can take into consideration reviewing your emergency money going, well, we're about to take out a margin loane.

9:59Speaker 2:We probably should bump up our emergency money before we take this loan out, so that should anything happen, we can.

10:05Speaker 1:You're actually preparing just in case things do go wrong and you need to stump up the cash to pay back part of that loan. You can do so.

10:12Speaker 2:You know, when it comes to these types of strategies, you're buying long term investments, So being forced into a position where we have to sell that quality asset just because of a natural market correction is a disastrous outcome that you want to avoid that at all costs. Another important thing to think about is the dividends. So when you set up this type of strategy, you obviously receiving dividends from your shares. So a way of actually managing that risk is you have the dividends paid to the margin loan to help pay it down, so you're creating more and more equity naturally reducing that LVR. You know, every six months when those dividends come in.

10:45Speaker 1:Okay or what sorry, no, I was going to ask you about that, because otherwise, when do you pay it back? Or is this just a loan that exists forever and you are just servicing the interest on it.

10:56Speaker 2:Most is such a great question. Most margin loans are actually set up as interest only. You can treat them like a principle and interest loan, which is what I did for the thousand dollars project I took out seven years ago. I took out a fifty thousand dollars margin loan and the portfolio was worth about one hundred and thirty at the time. And I put this on YouTube, and I had all these people like hammer Me saying this is so responsible. But my LVR was really conservative.

11:21Speaker 2:It was less than fifty percent. It was like thirty three percent or something. Oh a little bit more than that, but it was very conservative. And I actually chipped away instead of putting one thousand dollars into more shares, I actually chipped away the margin loan. So I actually paid that margin loan off. And that portfolio is now worth three hundred and eighty something thousand dollars today. So yes, those dividends can be used to help pay down the loan, or if you're able to service that loan, you can service it out of your own cash phone and continue on reinvesting their dividends and build your mindful money number.

11:50Speaker 2:So that's definitely an option there for you. But to answer your question about that loan, it's up to you. You can have that loan sit as an interest only loan and that it just sit there and always be there and you know, reap the tax benefits from it. Some people, which I never recommend, is they will actually have the loan capitalize, which not many loan providers allow anymore. Where he just gets all the interest gets out to the loan, the loan gets bigger and bigger. Oh boys, Yeah, that's just dangerous. And so yes, there are things you can definitely do to help manage this. And what I would say to anyone who's taking out a margin loan is you don't have to draw down the full amount immediately.

12:29Speaker 2:You know, yes, you may have been approved for say one hundred thousand dollars, draw it down fifty ten thousand, five twenty thousand. But also at the same time, and this is something I discovered, you've got to be careful as to what the minimum level they'll charge interest on. So as I was paying down one thousand dollars, project marginal loan of fifty thousand dollars, when I got to the loan down to twenty thousand dollars, I received an email from them saying and they had the margin had changed providers over the course of the seven years, but he sent me an email saying, your loan is now down to twenty thousand. Please know that we regardless of your loan size below twenty, we will be charging you interest at twenty thousand. So as soon as my margin loan went to twenty thousand dollars in under that interest rate became increasingly expensive. Every time I was chipping away.

13:19Speaker 1:Oh yeah, because otherwise you might only have one thousand dollars left to pay, but just still paying interest on twenty grand exactly.

13:25Speaker 2:So it actually gave me huge motivation to really pay it off, racking it quickly, and I did like I like high tailed, but I wanted that was part of my strategy. I wanted to pay it down. I wasn't interested in letting it just sit there at twenty thousand. So obviously the devil is in the details. You've got to understand this, but you can. You can treat it like a principle and interest loan and pay it off, but be aware of.

13:44Speaker 1:That catch Okay, all right, still a bit to cover. We'll take a quick break back in a moment. All right, Kenna, we have been talking about margin loans, and I set it up as this is going to answer the question powerful tool or dangerous trap. And I feel like the more I learned from you, the more I'm kind of heading towards the powerful tool part. But for the wrong person, a margin line could be a trap. They could find themselves over exposed, or they could find themselves in a bit of trouble. Who should avoid this strategy?

14:26Speaker 2:I would say inexperienced investors. This is something This is quite a sophisticated financial tool. So if you are new to investing, you've only just started buying shares, maybe wait a little bit until you're a lot more comfortable and understand that latural market volatility and you understand like your cash flow and what it looks like. Also, anyone who's already got toxic debt in their life, like they've got credit card debt by now, pay later, outstanding payments, personal ones, don't go and take out this type of investment debt until you've built your financial foundation first, Because.

14:59Speaker 1:Yeah, you are a essentially adding another big chunk of debt to your life, and you don't do it while your other debt is not under control exactly. Okay.

15:07Speaker 2:Also, people who don't have the timeframe you know, you know, if you're building a share portfolio with the intention of selling it down to pay for a deposit. A margin loan is a long term financial product. It is not a quick fix. It's not there to make quick cash. So you wouldn't if you're looking at closing off the portfolio using that money, taking that money off the table. This is not the tool to be using right now.

15:27Speaker 1:Okay. Misconceptions around borrowing to invest. Perhaps one of those misconceptions is that margin loans are a dangerous trap. But what is the biggest misconception I suppose that people have around this concept of borrowing money to invest when it's certainly not as tangible as theay borrowing to go and buy a property.

15:51Speaker 2:Okay. I think there are actually two misconceptions, the first being that leverage creates wealth. It doesn't. It definitely helps, but at the end of the day, it's the underlying investments that help create wealth, and reviewing it on a regular basis and investing in a consistent way is what helps build sustainable wealth. You know, leverage simply amplifies whatever happens. The second misconception is assuming that you are going to be emotionally calm and rational during natural market downturns, like history shows that most investors are the most emotional, sorry, more emotional than they actually expect. And there's this thing called a loss of version, which is a cognitive bias.

16:34Speaker 2:And what happens is we feel loss twice as deeper and more painful than an actual gain. So you can see your margin alone working for you, helping you build your portfolio, helping access more passive income streams, and things are swimming along nicely and you feel good. But then when a market correction happens, that pain is twice as more intense. Hence that in what you were feeling when you were feeling like everything's working nicely for you and swimming along okay.

17:05Speaker 1:So to some extent, this is as much a psychological thing as it is a financial decision you need to be And this goes back to probably being a slightly more sophisticated investor that you understand how markets work, the flow, the volatility, the fluctuations, and how you react emotionally to that before you put yourself at greater exposure. I suppose to that volatility. Yeah, absolutely, all right. Finally, if someone is curious right about margin lending, what do they need to understand before they even consider it? If this has been a fantastic deep dive into it, but if someone's come out of this and going, you know what, I reckon?

17:55Speaker 1:I reckon this could be something for me, what do they need to know right now?

17:58Speaker 2:Okay, So I do a bit of a checklist, and I would ask yourself these five questions, the first one being can I comfortably afford the interest? And can I comfortably afford the interest even with say a three percent interest rate rise? Because yes, you can fix margin loans sometimes, but you can normally only fix them for a certain period. And within this question as well is can I actually chip away at the loan? Is there going to be enough cash flow left over for me to slowly pay it down like I did with a thousand dollars project?

18:30Speaker 2:You know, having that buffer, that safety net is important to prioritize when you're looking at doing this. The second question I would ask myself is can I handle a margin call? Not just financially, but emotionally it's quite panicking. I've never personally received one, but I've watched people receive them, and it was quite debilitating, like what it did to them and their confidence, and you know, the mad panic to find money and to avoid having to sell, and you know, it's very distracting. You're trying to move through your everyday life and then have this massive financial risk land in your lap. So do I have the means to either come up with extra money to help reduce the LVR? Or do I have some share sitting in another online share trading account that I can transfer across into the portfolio to help rebalance it? You know, do I have the ability to actually sell some shares because I've already made lots of money on some of them to rebalance the LVR again? So you know, can I actually meet the margin call financially and emotionally? And of course you want to be your mindset would be very

19:30Speaker 2:much about avoiding a margin call at all costs. The other third question I would say is would I sleep well at night even if markets fell thirty percent? And this is where you can sort of see hate saying that's anything that can come to me at the moment, but the men from the mice. You know, when it comes to a high risk strategy like this, will I actually get excited that this is the buying opportunity that I've been waiting for? Or is this going to make me panic, shrivel up into my shell and question everything I've done. If your answer is I would panic and feel anxious, that doesn't necessarily mean this is the wrong strategy for you or the wrong product. It just means a little bit more time, a little bit more experience, and just a little bit more information as to how this works and how to manage this proactively before you jump in the deep end of this. The fourth question would be is am I investing for at least ten years?

20:28Speaker 1:Oh? Yeah? The timeframe this is really important.

20:31Speaker 2:I think a lot of people don't realize margin landing. It's you know, you go in it going yep, that's fine, I can do this amount of time. But you've got also go keep in mind if you are playing and pulling this money out of the market, your time frame is not ten years. It's nine years, eight years, six years, seven years. As you're approaching that point where you're going to take the money out. You want to make sure that that margin loan is either coming down so you can actually take all the money off the table to achieve that particular goal, or your portfolio has grown an off to clearly wipe that loan out and pay it off when you go to sell the portfolio, so that you can take your money off the table and use it for whatever you want. And then the fifth one is, am I borrowing this money and following this strategy because it genuinely suits my financial plan and compliments my other financial strategies, or am I just being greedy and chasing bigger returns here? You know, financial planning is never just a one strategy. It was rarely one strategy unless you're getting limited advice. There are lots of moving pieces around superannuation,

21:34Speaker 2:around saving strategies, around managing your debt, paying off mortgages, you know, saving up for short term goals. So there's a lot of things in here, and it should compliment what else is going on, and obviously compliment and help you work towards your big picture goal because it is a long term strategy.

21:51Speaker 1:Makes sense, okay, And of course go and get some professional advice if you've got any questions about this or thinking about doing it, then the best thing to do is to go and speak to a professional who can help you implement it and talk you through the risks as they are appropriate to your personal circumstances. Can if people want more information from you, they find you on Instagram.

22:11Speaker 2:If you have any questions about margin loans, especially something I really love talking about.

22:16Speaker 1:I have got that impression and we haven't.

22:19Speaker 2:Said this, but the thing about margin loans is it allows people to build wealth without having to own a property. You know, I said when people might own a property don't want to use their homo security. But also there are a lot of people out there who love their shareboot follower who want to keep building it but don't own property. This is a financial tool that might be really helpful to be able to access that equity opportunity.

22:42Speaker 1:All right, So jump onto Instagram, Sugar Mama TV for Canna, and you can hear me every day with Sean Aylmer on Fear and Greed business news. You can use. Thank you for listening to how do they afford that? Remember to hit follow on the podcast. And the best thing that you can actually do is tell somebody else send them a link to this particular episode if you think they might be intro us in it. Help us spread the word. Thanks for your company. Join us again next week.

23:08Speaker 1:H