Borrowing to buy shares is very popular, especially with those banks and brokers trying to sell you the loan.
Ever thought of borrowing to buy shares? If our subscriber queries are anything to go by, using debt, usually in the form of a margin loan, is a popular topic of discussion. What follows is an examination of the problems of borrowing to buy shares (the advantages receive way too much coverage in our view, and the dangers too little).
When a bank lends money, its primary concern is getting it back. That's why most loans require security, in the form of your home or car. Margin lending is simply a loan that uses shares as security. You put up some of your own money, the bank kicks in some more and you go off and buy a few shares. But the bank keeps all the shares under its control. That way, if things start going wrong, it can sell some of the shares to ensure it maintains its required level of security.
The bank determines how much it is prepared to lend based on how much capital you are putting up and which stocks you are going to buy. For some big blue chips, the loan-to-value ratio, or LVR, might be as high as 70%. This means that, to buy shares worth $1,000, you'll need to provide $300 of capital while the bank will lend you $700. Smaller or more risky stocks generally have lower LVRs. The benefits of a margin loan are simple. If you pick stocks which do well you'll make more money than a debt-free portfolio.
Unsurprisingly, this is the line pushed by lenders. On the Commonwealth Securities website (www.comsec.com.au) there's an explanation of margin lending and an example that shows (sort of) what would have happened had you purchased shares in Woolworths at $5.05 in March 1999 and held on for five years.
The example shows that if you used a margin loan to acquire extra shares, then you'd have made more money. Fair enough, although had the broker chosen Coles Myer as the example, it wouldn't be so impressive. And let's not even talk about tech stocks or other popular stocks from five years ago.
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