The Loan Hand- 14th August 2002
Peter Freeman - Bulletin
Taking out a loan for investment purposes is a risky business. Peter Freeman examines ways to minimise the peril.
Deciding whether or not to borrow to invest is challenging enough. Working out how best to do it can be even more demanding. While some investors will opt for one of the indirect gearing options, such as instalment warrants or internally geared funds, most people will probably decide to borrow directly. For this group their borrowing options largely depend on what assets they target and their financial situation, in particular whether or not they have a reasonable degree of equity in the family home.
Older investors – those in their early 40s or later – are likely to have only a modest mortgage compared with the value of the home, thanks both to rising real estate prices and their effort to repay the mortgage. People in this situation have the option to make use of a home equity/line-of-credit loan, a facility that gives them flexible access to borrowing at a relatively low price. For those who know what they are doing – and it should only be used by this group – this is probably the best source of finance for gearing into the sharemarket.
Peter Thornhill, head of Motivated Money, says home equity loans are not only relatively cheap but also have the advantage of avoiding the risk of being required to put in more funds should your share investments slump in value. This is what can happen with a margin loan, which involves using your shares or managed fund units as security for the loan. If the value of these fall, the lender will want you to put in more of your own money to restore the required loan-to-valuation ratio. In contrast, even if house prices slide, banks don't require investors to reduce the amount they have borrowed. The loan just operates as before. The rates charged on these, as well as other investment loans and margin loans, are available at www.cannex.com.au and www.infochoice.com.au
Alyson Clarke, head of technical services at BT Funds Management, says a margin loan, if used sensibly, also carries limited risk of triggering a call for more money. "The sharemarket has to fall a long way before most investors are likely to be hit by a margin call," says Clarke, although she stresses that this isn't the case for overly aggressive investors, who borrow to the hilt. "If you keep your gearing level down relative to your loan limit, the risk should be manageable."
In support of this view, BT looked at a range of situations to see how big a fall in the value of someone's share investments would have to be to trigger a margin call. As the accompanying table shows, the key is to borrow quite a bit less than your loan limit. For example, someone who is able to borrow up to 65% of the value of their investments but who only borrows 50% wouldn't be hit by a margin call until the value of the investments had fallen by 33%. If the investor was more cautious, and drew down only 40%, then the market would have to fall 47% before a margin call was triggered.
The main proviso here is that the calculations include a 10% "buffer". While this is usually available on managed funds, the buffer on direct sharemarket investments is often only 5%.
The buffer is the amount by which an investor can exceed the loan limit without triggering a margin call and exists partly to provide additional leeway should the market suffer sudden swings, as has been the case on Wall Street recently. The buffer, however, is a genuine feature of most margin loans and so this fact doesn't invalidate BT's calculations.
Margin loans, including the relatively new version that allows you to establish a geared savings plan, are only available for direct sharemarket and managed fund investments. Investors who want to gear into property need to use either a home equity loan or an investment loan, or a combination of both. This approach could involve taking out a home equity loan, also often known as a revolving line of credit, over the family home and then drawing on part of that facility to provide the deposit for an investment property. The rest of the purchase price would be financed by an investment loan over that property, with the result that you are 100% geared.
Such a strategy is obviously extremely aggressive, although not necessarily foolish provided you have a long-term investment horizon and a secure cashflow to meet the interest cost, including an allowance for possible rate rises.
It is certainly a lot less dangerous than emulating the recent behaviour of some investors who gear into multiple off-the-plan apartment developments using no more than a series of deposit bonds: guarantees to the vendor, usually backed by an insurance company, that the 10% deposit will be forthcoming when the purchase is completed. The hope, in most cases, is that the property can be sold for a profit before completion.
Even sensible gearing entails quite a lot of risk and so should be approached with caution and careful planning. That sort of gearing strategy, however, should be avoided completely.