When you're looking to borrow money from investment purposes there are two common types of loans that you can look at - margin loans and home equity loans.
What Is A Margin Loan?
Margin loan allows you to borrow money to invest in shares or other financial products whilst using the asset as security for the loan. This is different to other kinds of borrowing because the lender has the right to sell the shares if the value of the investment falls below a required minimum value. The sale proceeds are being used to reduce or repay the debt.
The main reason for using a margin loan is to provide access to investment markets with the goal of achieving your financial goals more quickly. It also allows you to use your existing equity in investments as the loan security. I've seen margin loans used by people who want to raise capital to make other investments without the need to sell their existing investments. It can also be used to help diversify an investment portfolio as it provides more funds for investment.
Let's say you have an existing share portfolio of $100,000. Your could obtain a margin loan of $100,000 to invest into more shares or other investments. This would give you a total portfolio of $200,000. Assuming your new investment provides an annual return greater than the after-tax costs of the margin loan, you're in front.
Maybe you don't have any shares but you've save up $20,000 to invest. By using a margin loan, you could invest the initial $20,000 into shares, borrow $20,000 on a margin loan and invest this into more shares. You'd end up with a total investment of $40,000 instead of the $20,000 you'd have invested without the loan. Once again, as long as the value of the investments grow at a higher rate than the after-tax loan cost, you're doing well.
Off course there are downsides to margin loans. If your investments make negative returns you run the risk of having a margin call where the lender wants their loan reduced or repaid. Your two options are to either sell some of your shares to reduce the debt, or use additional money to reduce the debt. Of course, no-one wants to sell investments when they're down, so you need to be careful and make sure you don't gear your investments at a high debt to investment ratio.
What Is A Home Equity Loan?
Home equity loans are a good way for investors to access some of the equity in their homes. This enables you to borrow money at home loan rates (which are generally lower than the rates on margin loans).Â This money can then be used to invest into shares or other investments that are expectedÂ to provide a return greater than your interest cost.
Many Australians have equity in their homes.Â By using a home equity loan they are able to make use of this equity to invest for their future. Because many people haven't saved enough for their retirement, this could be a good way to accelerate your retirement savings.
One of the big advantages of home equity loans is that there are no margin calls. Because the debt is secured against your home, the lenders are not concerned if your investments decrease in value.
Which Is Right For You?
Margin loans can be useful for people who don't own real estate or don't want their homes to be used as security for any investment debt.Â Home equity loans are good for people who are comfortable with the family home being used as security for their investment loans, as it enables them to access finance at a lower rate of interest than a margin loan.
Which one is right for you depends on your personal needs and circumstances. For decisions like this, it's always best to obtain professional accounting and financial advice to make sure you can make the best decision.