Posted by Ask_Josie on Nov 2nd, 2008

Q. Approx 2 years ago I took out a margin loan agreement offer by a financial adviser. I borrowed $140,000, plus $70,000 of borrowed money as security. Back in June as share prices fell I have was asked to top up approx $30,000 to maintain LVR.

I was able to to this by redrawing equity from my home loan. I am expecting to need to do this again soon as share prices continue to fall. My question is - Is it foolish to continue to use borrowed money (E.G. Redrawing funds from my home loan) to maintain my margin loan? Thanks very much for this opportunity to hear another opinion. Regards Allen.

Josie’s answer.   Is it foolish to continue to use borrowed money and perhaps be throwing good money after bad in your margin loan?   Good question and the answer lies in your cash flow (income you can generate at the moment and in the future) and whether you are prepared to ride out this volatility (I think we need to be prepared to hang in there for at least 5, probably closer to 10 years - yes I am being conservative, but we are in the middle of financial storm and nobody knows what damage has been done to major economies around the world).

The advantage of topping up your margin loan is that you are buying cheap, with plenty of experts arguing we are buying bargains (they also said that a few months ago!).   The alternative is that you will have no choice but to reduce your holding, and therefore crystalise losses.   Your losses are ’real’ rather than a ‘paper loss’.   Thank God,  interest rates are more likely to go down than up.   You are paying interest on $240K, probably around $20K per annum.    Income on share investments is usually around 3%, but who knows if this will continue.   Therefore, your investment is giving you a negative return at the moment, and the difference come out of your savings.   Luckily the tax man helps a little with cashflow as the interest payments are tax deductible, which means you will geting a tax break of up to 46.5%.  Most of us, are paying 31.5% (earn less than $80K).    In case people are wondering, LVR, stands for ‘loan to value ratio’.  When you take out a margin loan, if your investment goes below a certain value, the lending institution asks you to add money, or sell part of the investment to retore it to the right level.

What should you do?   The reality is that the only thing you can control with an investment are the fees (and only to some degree).   Things are not looking great for the sharemarket in the short term, and nobody rings a bell when we are at the bottom or top.    Your financial planner is being remunerated so please don’t feel you would be bothering him or her.   I highly recommend you sit down with them to revisit your short, medium and long term goals and be doubly sure that your cashflow will be enough to ride out this volatilty.   I am assuming your adviser is receiving an annual service fee based on a percentage of your investments, plus commission from the margin loan, as well as any insurances you may have taken out.  Are you paying a fee on contributions?     The biggest mistake people make is thinking their financial adviser has all the answers on the best place to invest.  Nothing could be further from the truth.  If we did, then we wouldn’t need to work as a financial adviser (same applies to stock brokers, real estate experts etc).   The best description is probably ‘financial coach’.   We can help you organise your financial life and give you guidance on achieving your goals and objectives, in particular, funding for a comfortable retirement.   A simple definition, and of course we are all different.

Borrowing money for investments can be an effective strategy long term to create wealth.  However, this strategy can also magnify losses (and gains) so if the timing is not right, you can do lots of damage to your finances.

To sum up, after consulting your financial planner, use your own gut feeling as to what you should do.  If you do decide to hang in there and if the need arises, you are required to top up your margin loan, you must be committed long term to the investment.    If you do not, then you just have to accept a loss.   As I said earlier, it all depends on how much you earn and hope you have surplus savings as your loan is increasing, not decreasing, which all equals to high interest costs.   Also hope you are young and able to ride out this crisis.

Isn’t hindsight a wonderful thing?   I lived through 1987 and lost a little on my share investments (didn’t have much then).   It always feels worse, but they tell us it isn’t.

Take care and hope it all works out for you.

Cheers

Josie Kay