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 Financial Happenings Blog 
Tuesday, July 08 2008

The first 6 months of 2008 have provided some "interesting times" for "margin loaners".  The sharp fall in the Australian share market through the first quarter and now again in June has led to surges in margin calls by lenders.  Monday's Fin Review suggested that margin calls rose 10-fold on Thursday last week.  Margin calls in the first quarter of the year jumped to 3.85 per 1000 investors up from between 0.25 and 1.04 in 2007.

 

There have also been a few notable collapses of firms encouraging their clients into such loans - Opes Prime and Lift capital the better known of these.

 

At the same time interest rates have risen.  The Reserve Bank set the official cash rate target at 4.25% in December 2001.  This rate has been raised with the latest rate rise in March leaving the official rate at 7.25%.  Cannex and RateCity.com.au, two organisations that list the latest interest rates in the market, have the best margin loan rates at the moment sitting at 10.25%.

 

Given these observations, taking out a margin loan under the present conditions looks hazardous at best.

 

However, investing is about looking forward.  If you consider some of the fundamentals in the market there may be some good buying to be had.  The Fin Review on Saturday had the ASX200 Price Earnings ratio at 11.37, well below the historical averages of around 14.  This is basically telling us that shares are cheap at the moment.  Dividend yields for the same index are at 4.54% with many "Value" companies like the major financials on much higher yields as well as being fully franked.  Let me put on record that our firm does not attempt to predict short term market movements, however we do look at the long term realities of markets to suggest that sometime in the future there will be a significant upswing in markets.  Knowing when this will happen is the difficult part.

 

So what is our approach to considering borrowing to invest in the current climate?

 

Our firm is quite conservative by nature.  We would never be suggesting that investors heavily gear up, especially in terms of margin loans.  Rather we would take a measured approach considering the fundamentals.  The key consideration is that if you choose to borrow to invest you must have an expectation that the returns from the investments, on which you used borrowed money to purchase, will be greater than the cost of the loan.

 

Let's first look at determining the cost of the loan.  For simplicity, let's assume you want to borrow $100,000 at the best margin loan interest rate of 10.25%.  The interest payments for the year will be $10,250.  You can deduct these payments from your income for the year to reduce your tax so the after tax consequences are as follows:

 

Marginal tax rate

Tax Reduction

After tax cost of loan

Effective rate after tax

46.50%

$4,766.25

$5,483.75

5.48%

41.50%

$4,253.75

$5,996.25

6.00%

31.50%

$3,228.75

$7,021.25

7.02%

16.50%

$1,691.25

$8,558.75

8.56%

0%

-

$10,500.00

10.50%

 

This effectively means that your after tax returns from your investments would need to be better than this effective rate.

 

What this clearly shows is that borrowing money to invest in cash or highly rated fixed interest securities does not make sense.  Let's assume you invest the $100,000 in an online savings account earning 8% ($8,000 of interest for the year).  The after tax returns would be:

 

Marginal tax rate

Tax

After tax return

Effective rate of return

46.50%

$3,720.00

$4,280.00

4.28%

41.50%

$3,320.00

$4,680.00

4.68%

31.50%

$2,520.00

$5,480.00

5.48%

16.50%

$1,320.00

$6,680.00

6.68%

0%

-

$8,000,00

8.00%

 

This shows that by having any of the loan invested in cash you would be going backwards.  Therefore you would need to invest in assets like Australian shares, international shares and listed property in order to beat the cost of the loan.

 

Let's consider Australian shares, with a dividend yield of 4.54% for the ASX 200.  The average franking credit level on the ASX200 is approximately 80%, which would provide franking credits equal to 1.14% providing a grossed up return of 5.68% ($5,680).  After tax this would leave you with:

 

Marginal tax rate

Tax

After tax return

Effective rate

46.50%

$2,638.88

$3,036.13

3.04%

41.50%

$2,355.13

$3,319.88

3.32%

31.50%

$1,787.63

$3,887.38

3.89%

16.50%

$936.38

$4,738.63

4.74%

0%

-

$5,680.00

5.68%

 

To warrant borrowing to invest you then need to expect that the capital growth on your investment (growth in share price) will be greater than the difference between the after tax dividend return and the effective rate of the loan after tax.  In our example you will need to get the following capital gains assuming a buy and hold strategy (i.e. applying the 50% discount rate to all of the capital gains)

 

Marginal tax rate

After Tax capital gain

Before tax capital gain

46.50%

2.45%

3.19%

41.50%

2.68%

3.38%

31.50%

3.13%

3.72%

16.50%

3.82%

4.16%

0%

4.58%

4.58%

 

The average before tax capital gain of the Australian share market through history is somewhere between 6 & 7%.  On these numbers the borrowing to invest strategy seems to make sense.

 

That being said, if you had geared up in late October, early November the strategy would have resulted in a less than rosy return up to now.

 

Some other considerations to weigh up

 

Some other factors need to be considered before deciding either way.

  • What is going to happen to interest rates?
    • Falling interest rates would improve the scenario whilst increasing rates make it more difficult.

  • Can you access a home equity loan?
    • If you can, the interest rate could be as much as 1% lower than the best margin loan rate.  I won't do the maths on that here but it would definitely improve the chances of beating the effective loan rate
  • What if I am an active style investor?
    • Firstly we would consel you against such an approach, but if you could not be persuaded, you would need to factor in some extra capital gains tax pushing the needed before tax capital gains a touch higher than those mentioned above.

Final Thoughts

 

The maths looks promising especially for those on higher marginal tax rates however there is a huge elephant in the room - what is going to happen to shares in the next year?

 

Some experts predict the ASX200 could call a further 30%, down to 3,500 from the curent level of 5,000, whilst others suggest it could get back to historical highs in the new year - 6,800 or a 36% rise.

 

This is the key question and unfortunately one we do not have the answer for.  What we do know is that taking on more debt adds risk to your situation.  Increased risk levels can lead to increased returns over the long term but can also have a devastating impact.  This risk needs to be weighed up by each individual investor according to their own personal circumstances and preferences before even contemplating borrowing to invest.

Posted by: Scott Keefer AT 07:45 pm   |  Permalink   |  Email
 
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