Chapter 15 – Borrowing to invest in shares

Shares can be purchased using borrowed money in a variety of ways. Given the nature of shares, typically an investor will be looking for a flexible debt facility which allows shares to be purchased and sold over time. This distinguishes the gearing of shares from the gearing of property, for example, where a single loan facility is often raised at the point of purchase and the debt is secured by a mortgage against the purchased asset.

As a general proposition – and we are very much talking in averages and the long term here – borrowing to buy shares is a good idea. Economic theory holds that the cost of borrowing will be lower than the average return available to borrowers deploying the borrowed funds. If this were not the case, the demand for borrowed funds would reduce, and this would in turn cause downward pressure on interest rates… with this process continuing until the interest rate on borrowing would be less than the rate of return generally being achieved.

At least, that’s the theory. The recent experience has been similar. In the 20 years to December 2014, the average annual rate of return on the ASX was 9.4%. This was, at most times, a few percentage points higher than the rate at which share market investors could borrow during that period.

The following sections discuss various elements involved in borrowing to buy shares.

Securing the debt against some other type of asset

Secured debt is typically cheaper debt. While money borrowed to buy shares can be secured against those shares (see below), the cheapest type of debt is typically that secured against residential property. Accordingly, the cheapest way to gear into shares is often by using a loan secured against a piece of residential property.

One simple example here is a line of credit secured against the investor’s home. The investor draws against the line of credit, only paying interest on the amount of the loan outstanding at any point in time. The shares can then be bought and held unencumbered.

This form of borrowing of course requires that the investor have equity in a property and a lender prepared to allow a line of credit to be drawn against it. With regard to this preparedness on the part of a lender, that lender will be looking at the combination of available equity and ability to pay any interest being incurred on the loan. Often, the limit that is set on the line of credit is the limit at which the lender is prepared to lend given the asset and income profile.

A similar example is a standard loan secured against residential property. This loan can be either a principal and interest loan or an interest-only loan. In this situation, the loan is drawn and the funds are deposited somewhere in readiness for investing. In this situation, interest is payable on the full amount drawn, regardless of whether that full amount has been invested. This type of loan can therefore be a little unwieldy.

Deductibility of interest secured against an asset other than the shares being purchased

When debt is secured against some other asset, and that asset is a private asset (that is not used for income-generating purposes), there is a common misconception that the interest on the debt is not deductible for tax purposes. Whether interest is deductible depends on the use to which the debt is put, not the asset against which the debt is secured. If the money is used for income generating purposes (which would include buying shares in almost all circumstances), then the interest should be deductible.

Where the same debt facility is used for a mix of private and investment purposes, the interest is only deductible for the portion that was used to invest. In addition, where the same debt facility is used for a mix of purposes, any money repaid into the facility is apportioned between the private and investment purpose. It is not possible to repay the ‘private component’ first.

For that reason, it is usually preferred that money borrowed to invest be drawn from a loan account that is only used for that purpose. If the borrower wishes to use borrowed money for investment and private purposes, then he or she should use two or more separate loans. This will maximise deductibility and also allow for the prioritised repayment of the more expensive private debt.

Securing the debt against an asset owned by another legal person

This is actually quite common. One of the most common ways for this to happen is for the debt to be secured against a residential home and then shares to be bought in the name of a company or family trust. Other common examples include where the debt is secured against, say, a home owned in the wife’s name and used to buy shares in, say, the husband’s name.

In these cases, care needs to be taken in terms of how to ensure that interest on the debt is tax deductible. If the interest is incurred in the name of one person, but the shares are held in the name of another, then the interest will not be automatically deductible for the first person. This is because he or she is not using the money to generate assessable income.

The situation can be ‘put right’ through use of things such as private loan agreements. How these agreements are best enacted will depend on the specific arrangements being considered. It is difficult in training materials such as these to address all of these arrangements so for now we will simply reiterate that interest is not automatically deductible if the borrower and the investor are not the same person and suggest you contact MLA Lawyers or some other registered tax agent if you wish to learn more about a specific situation.

Securing the debt against the shares being purchased

It is possible to secure debt against the shares being purchased. This type of facility is typically called a ‘margin loan.’ In this form of loan, the lender takes a charge over the shares and can order that the shares be sold to repay the loan.

Lenders typically lend investors an amount equal to 65-70% of the value of the portfolio being held or acquired. That is, the LVR is typically 65-70%. The investor must provide the remaining 30-35% of the value of the portfolio from elsewhere. They may use their own equity for this, or use money borrowed from elsewhere.

The term ‘margin loan’ comes from the fact that the lender wants to keep the value of the debt within the prescribed margin (i.e. between 0% of the value of the portfolio and the nominated LVR). The value of the financial instruments on which the loan is provided are often quite volatile in the short term. This means that the value of the portfolio may also be subject to rapid change. Where the value of the portfolio falls to the extent that the level of debt exceeds the prescribed margin, the lender will require the borrower to do one of three things:

  1. repay some of the loan
  2. provide further assets as security; or
  3. sell some of their holding and use the proceeds to repay some of the debt.

When the lender does any of these things, it is known as a ‘margin call’. Most lenders allow a little leeway in the value of the financial instruments before making a margin call. This leeway is known as a ‘buffer’. Some lenders allow a buffer of 5% over the prescribed margin of (say) 70%. This buffer is designed to reduce the need to take action when a financial instrument temporarily dips in price and the prescribed margin is exceeded.

Interest rates on margin loans are typically higher than for loans secured against property. This reflects the fact that there is generally a greater risk that the financial instruments used as security will fall in price over the shorter term. This increases the risk that the lender will not be able to retrieve the loan amount. The lender increases the interest rate to compensate for this increased risk.

Margin loans can operate in one or both of the following ways:

  1. as a line of credit; and/or
  2. as a means of increasing an amount being invested.

To use a margin loan as a line of credit, a borrower needs to already own some shares. They offer the lender security over these shares and, in return, the lender makes some loan monies available to them. The borrower is free to use these loan monies in any way they like; this may or may not mean that the loan is used to finance further investment. (If the loan is not used for investment, then the interest is unlikely to be tax deductible – see below).

To use a margin loan as a means of increasing the amount being invested, the borrower deposits some of their own money into the margin loan account. The lender adds some loan money and makes a purchase of financial instruments on behalf of the borrower. The lender retains a charge over these assets.

Margin loans were popular with clients up to the GFC. But harsh margin calls and high interest rates between 2008 and 2011 caused a lot of pain. Memories linger and in 2016 margin loans remain relatively unpopular with clients.

Deductibility of interest incurred on a margin loan

In the section above we discussed the popular misconception that money borrowed against private assets does not give rise to deductible interest, even if the money is used for investment purposes. There is a related misconception which states that interest will be deductible it is secured against income-generating assets, as a margin loan is.

This is also not necessarily the case. Money borrowed against shares does not give rise to deductible interest if the money is used for some private purpose. In order for the interest to be deductible, the money drawn must be used for an income-generating purpose.

Using unsecured debt to finance the investment

This is relatively rare. The reason for this is a simple one: unsecured debt is expensive. The indicative rate for a personal loan as of February 2016 is 14.1%, compared to 5.9% for an investment property loan.

This high interest rate creates a required rate of return much higher than the long-term average for Australian shares of 9.4%. As a result, few people use this form of debt to finance a share investment.

Credit licencing system for credit advice

Since 1 July 2010, Australia has implemented a national licensing scheme to regulate people (natural and/or legal) who engage in credit activities in relation to consumers. This scheme is implemented under the National Consumer Credit Protection Act 2009 (Cth).

Please remember that only licenced providers of credit advice can advise on specific credit product. This is discussed here

The Dover Group