Why Borrowing To Save Makes Sense

Sun Herald

Sunday June 22, 2008

David Potts

DAVID POTTS gives his expert guidance on how you can make margin loans work to your advantage without suffering the indignity (and panic) of a margin call.

The shortest distance between two points is a straight line, but not when it comes to money. No, a detour is better nearly every time. The best way to save a deposit for a home, for example, isn't really by saving at all. That'll take forever, and you'll be taxed on the interest anyway.

A short cut is to take out a margin loan and buy shares or an index managed fund.

Borrowing to save sounds like a contradiction, except that the interest is tax deductible, you get a 30percent rebate on franked dividends and, best of all, by the time you sell them to take out your home loan, the capital gains tax will be at half your normal rate.

If you already have a share portfolio and want to take advantage of depressed property prices to buy an investment unit, a margin loan is still an option. This time you borrow against your share portfolio and use it as equity for an investment loan.

Then again, you could expand your portfolio without having to sell any stocks.

My favourite is using a margin loan as an overdraft - it's much cheaper than the alternatives if you don't have a line of credit on a home loan. So long as you already have some shares, you can draw down more funds as you need them.

Then there are the tax breaks. Since June 30 is a week away, remember the interest on margin loans can be prepaid and claimed.

Running a margin loan side-by-side with a mortgage can also pay dividends, so to speak. You claim the interest on the margin loan but use the dividends to help pay off the mortgage. That gives you a bigger deduction for longer.

Because tax rates are about to drop, prepaying next year's interest on a margin loan is especially attractive this year.

It's always better getting a deduction in a year that your tax rate is higher. This will suit the self-employed or anybody close to retirement, about to go on maternity leave or work part-time, not to mention high-income earners. Oh, and anybody so disorganised - no need for any names - that they need a last-minute deduction to forestall a looming tax bill they haven't prepared for.

Mind you, claiming interest in advance isn't a tax saving, but a deferral.

I know the sharemarket is nothing to write home about at the moment. But is property any better? Either way you're taking a risk. At least the sharemarket will snap back at some point, and it's in the first few weeks that bull markets are the most profitable. So not being in the market can hurt because of the lost opportunities. But surely margin loans only make it even riskier? And how about those poor souls who borrowed from Opes Prime only to discover they didn't own their shares anymore?

* AT THE MARGIN

Glad you asked, because there are two cardinal rules of margin lending.

One is that you have to trust who you're dealing with, and none of the well-known margin lenders take ownership of your shares. They stay in your name through thick and thin.

Even ANZ which seized the shares that Opes Prime had leant against wouldn't dream of grabbing them off its own clients.

"The shares stay in your name. What's more, we can't lend them to anyone else," said John Daley, head of ANZ-owned E*Trade.

The other lesson is that using margin loans for just one or two shares is inviting disaster.

Margin calls sound horrific all right. Because you have to maintain an agreed level of equity in your, er, equities, a drop in the share price means you have to top up in some way. You can either put more cash in or sell some of the stock.

Usually, putting more cash in is the way to go unless you've picked a dud stock in which case your margin lender might save you from yourself. Banks are like that.

Only if the stock goes belly-up will the lender take possession, but by then it's pretty academic anyway; unfortunately it will also have a claim over your other shares or assets in order to recoup its money.

To avoid having the rug pulled from under you when your lender sells stock as its price is dropping, keep your level of borrowing or gearing down.

A margin loan is ridiculously easy to sign on for - you don't even need a minimum income - and you can borrow up to 80percent of the value of a good stock. This is called the loan-to-valuation ratio or LVR.

But resist the temptation and borrow more conservatively. If you borrow half and put up the other half - in which case the LVR is 50percent - it would take a massive 33percent drop in the market to get a margin call.

At 70percent, however, it takes a fall of just 6.7percent for a margin call.

In this market that can happen to a stock in a day. In five minutes, even.

On top of the protection from low gearing, margin lenders give you a buffer on this buffer. Ranging from 5 to 10percent of the value of a stock, this gives you an extra margin before there's a demand for money or else.

So with an LVR of 75percent, the real danger point comes when your equity drops below 20percent.

The only catch is that if the share price drops further and you do get a margin call, you have to make up the whole buffer and anything else, in which case you have to get back to your 25percent equity (where your LVR is 75percent) quick smart.

* PLAYING IT SAFE

Diversification is the other safe house. The more stocks you have in a portfolio, the safer it is. That's because invariably there'll be something that bucks the trend, whether the market is rising or falling.

There's another benefit, too. Lenders, as a rule, will take the value of a portfolio into account, rather than decide a margin call stock by stock.

Just think, you can still have a punt on a spekkie or two and not lose the family home if it tanks, so long as everything else has kept its value. A way to get instant diversification and save a lot of bother is to buy units in a share fund or, better still, a so-called index fund which copies the ASX200.

Lenders such as ANZ and St George will even let you invest monthly in a managed fund and match your contribution with a top-up loan. That will double your return since you have twice as much in there.

For the more adventurous, you can be a sort of do-it-yourself Macquarie Bank.

Daley suggests choosing put options - that is, an option to sell a given stock at a given price before a given date - when you use a margin loan on a stock.

Since E*Trade will lend against put options on a blue chip such as BHP Billiton, you can borrow virtually the entire amount when you combine them.

In return almost all your capital is guaranteed, since a put option lets you sell the stock at the price it was when you took the loan.

"You have to pay for the put option but you wind up with a guarantee of most of your capital and quite highly geared," said Daley who likens it to a capital protected loan.

* WHAT YOU PAY

Since the interest you pay on a margin loan is tax deductible, the minor variations offered between lenders don't make much difference.

They're about 10.5percent, give or take a rate cut and it depends on how much you borrow - though, since you asked, the cheapest rate for a $20,000 loan is Suncorp's 10.3percent.

The bigger issue, just like a mortgage, is whether to float or fix. But unlike a mortgage, at least there are no fees.

Come to that, it's even possible to get a margin loan at almost the same price as a mortgage although you have to borrow big time and fix the rate.

NAB's margin loans cost 9.55percent for two to five years, only 0.09points more than its standard home loan rate, if you're willing to borrow at least $1million.

Funnily enough, fixing is slightly cheaper than staying variable, and there's an extra tax benefit as well.

If you're fixing, you may as well prepay next financial year's interest before June 30, giving you a handy tax deduction in advance.

The cheapest $20,000 loan fixed is 10.1percent for five years from Leveraged Equities.

With some lenders you can even forward fix. That means you can take today's fixed rate offering and use it in six months.

Either way, don't forget that once the interest rate meter starts ticking, your investment needs to perform that much better to stay ahead.

And so a share portfolio geared at 50percent would need to grow by about 5percent a year just to recoup the interest cost. At 75percent gearing, there's a 7.5percent-a-year hurdle before you see a profit.

Since interest rates don't differ much, how do you choose between lenders? By the LVRs allowed, the size of the buffer, and which stocks or managed funds you can gear. You can get all this from www.infochoice.com.au or www.cannex.com.au.

There are no monthly fees, and the start-up cost ranges from CommSec's $135, through E*Trade's $150 and up to $200.

A super way to gear

THERE'S a new twist on the old question of whether gearing is better than super.

The answer used to be gearing because you're putting more money to work. Even if it's mostly someone else's.

The more you borrow the better so long as - a huge qualification, needless to say - it's invested well.

And if it's in blue-chip shares, then the 30percent franking rebate makes it a no-brainer.

Although super seems to start well because you've got 85percent after salary sacrificing to invest, gearing gives you 100percent to start with.

So there's more money working for you even though you're paying interest, which is tax deductible.

A share portfolio geared at 70percent with a margin loan will grow - or shrink - 3.3 times faster than if you own the same stocks without any borrowing.

Once you get into your 50s, it's true that super comes into its own, especially considering it's tax free after 60. But why not have the best of both worlds? Especially when you can use a margin loan inside your super fund.

That's right, you can salary sacrifice into super, using it as collateral for a margin loan to boost your returns.

The only difference is that the lender can only make a claim on the stocks you buy with the loan, not the rest of your super fund.

Bell Potter's new Super Lending comes with no start-up fees and a quarterly 0.25percent charge.

There's a modest list of 55 blue chips and two index funds tracking the top 50 and 200 stocks you can borrow against, and the minimum loan is $50,000.

By the same token, the gearing is limited, too. You can't go past 50percent, and for many stocks it's 40percent.

To make up for the lender's higher risk, the interest rate is also higher than normal margin loans at 11.5 percent.

© 2008 Sun Herald

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