Benefits of Margin Lending
There has been much chatter in the media recently about Elon Musk’s purchase of Twitter.
One of the less-covered aspects of the story is the fact that he is funding a large part of the deal through margin loans. But, what are margin loans and how can we mere mortals use them to our benefit too?
Margin loans (also known as lombard loans) are an effective way for individuals to borrow low cost, short term money.
However, despite their benefits, awareness of margin loans is relatively low, with many potential borrowers missing out on the opportunity to secure finance with terms that suit them.
Unlike a mortgage or a traditional loan, the advantage of a margin loan is that it can be used to finance anything, for example to purchase property, provide cash flow to a business, or reinvest in stocks investment funds.
Margin loans are quick to arrange and can be secured using almost any asset as collateral with favourable terms to meet individual circumstances.
In short, they are a valuable way of borrowing higher amounts of money with lower costs.
The practicalities of margin lending
Margin lending works by using the existing assets of an individual to leverage against in order to raise an additional sum of money.
For example, a potential borrower may wish to use their portfolio of shares as collateral to secure their margin loan.
The borrower’s share portfolio (or the portion they wish to use) is assessed and valued and they are offered a loan to value figure – the percentage that they can borrow versus the value of their portfolio.
In simple terms, a borrower with an investment portfolio worth £2m may be offered a loan to value of up to 50%, meaning they can borrow up to £1m.
They can then use this £1m to invest in property, a business or even reinvest in their existing investment portfolio so that they now have £3m invested.
The latter is known as “gearing” a portfolio and it has the potential to greatly magnify investment returns (and losses!!).
Terms are negotiated based on the borrower’s individual circumstances and their ability to repay the loan and, as with a traditional loan, the borrower will be required to pay interest.
In Elon Musk’s case, he is borrowing against his shares in Tesla to purchase Twitter instead of simply selling them to raise the money.
This has a double of benefit for him of allowing him to retain his control of Tesla while avoiding paying capital gains tax on their disposal.
Margin calls – what are they and why you should be wary of them
One key feature of margin lending is that borrowers are required to maintain a minimum amount of equity in their margin account.
This is to ensure that the loan can be repaid should there be a fall in the value of the assets used as collateral.
Should the value of the assets being held as security drop below a certain level, then the lender will make a margin call and the borrower is under obligation either to pay down the loan or top-up the collateral assets.
If the borrower fails to take either of these measures, then the lender has the right to sell the assets put up as collateral to recoup their loan.
This obviously creates risk. If, for example, your loan is secured against shares and the market drops significantly, as it has done this year, then you may be forced to liquidate assets to cover loans at a time when the price of these assets is severely distressed.
Why liquidity is key to margin lending
The key to securing the most favourable terms is liquidity.
The more liquid your collateral assets are, the lower the amount you’ll be required to hold in your margin account. This is due to the fact that should the lender need to sell the collateral assets for cash, in the event of the borrower defaulting on their loan, easily sold assets are more attractive.
In terms of asset classes, the most liquid is cash, followed by bonds and shares.
When it comes to shares, a portfolio of shares invested in higher risk stocks, such as AIM listed companies or emerging markets, will be less attractive than a solid FTSE 100 share portfolio and so the margins offered against these two will vary.
What are the benefits of margin lending?
1. Ability to borrow high amounts of money at a relatively low cost, perfect for making large purchases such as real estate.
2. Terms are negotiated to suit individual circumstances.
3. Margin loans can be arranged quickly should the borrower need a line of bridging credit.
4. By using existing assets as collateral, the borrower can still benefit from any rise in the value of those assets. If they were to be sold in order to free up cash, no future gains in value would be realised.
5. Margin loans can be used to gear a portfolio in order to improve potential returns.
Conclusion
Although margin lending has historically been viewed as a way for billionaires to raise extra funds without having to pay tax on their gains, margin loans are increasingly being used in place of a traditional mortgage to buy real estate, as a deposit towards a mortgage or to increase returns on a retirement portfolio.
They can also be used as a bridging facility for borrowers who need a quick, short term line of credit.
One thing is for sure, if billionaires such as Elon Musk can use margin lending to buy Twitter then it’s likely that awareness around margin loans will increase.
