Borrowing to invest

Lenders are overhauling their margin loans in a bid to overcome investors' reluctance to borrow to buy shares and managed funds.

Westpac's wealth management division, BT Financial Group, has launched what it is calling the "next generation" of geared equity investment products, including a loan secured by investment assets but with no margin call, and a protected loan that gives borrowers the flexibility to choose the level of capital protection.

The Commonwealth Bank is marketing a protected loan with similar flexible features. And Leveraged Equities also has a product that does away with the margin call.

Apart from the general lack of enthusiasm for sharemarket investing since the financial crisis and the 2008 bear market, two factors that have contributed to the decline in margin-loan balances are borrowers' dislike of exposure to margin calls and high interest rates on protected loans.

Lenders hope their new products will overcome these hurdles.

But it will be a tough sell.

Financial planners are taking an extremely cautious approach to margin loans or any other form of gearing to buy shares of funds.

The head of the financial advisory division at Dixon Advisory, Nerida Cole, says the firm is not recommending gearing into equities. "We are concerned about the level of volatility in the equity market," she says. "Investors need strong capital growth in the investment to make a gearing strategy work. At the moment there is a high risk that gearing will only magnify losses.

"At this time of year we see investors get excited about margin loans because of the tax advantages. But the tax benefit has to be a secondary consideration. You have to expect the investment to grow before you gear into it."

An executive financial planner at Westpac Premium Financial Services, David Simon, says one of the problems with margins loans at the moment is that they are expensive. The standard BT margin loan rate is 9.34 per cent - more than 2 per cent higher than a home loan.

"There is a wide disparity between a home loan and a margin loan at the moment because of the volatility in the sharemarket," he says. "If investors want to borrow to invest, we are steering them towards a home-equity loan where the cheaper rate will have less of an impact on their cash flows. If the investor doesn't have equity in the home we might recommend a margin loan but it would be on a very conservative loan-to-valuation ratio and with significant contingency planning."

Total margin loan balances in Australia have fallen from a peak of $41.6 billion in December 2007 to the current level of $14.9 billion.

One of Westpac's new products is the BT Professional Investment Loan, which offers a loan secured against investment assets but has no margin loan.

The borrower must choose from an approved list of diversified Australian equity and must accept lower gearing levels than would be allowed with a conventional margin loan.

In 2009, Leveraged Equities launched a similar product - an investment loan called the Investment Funds Multiplier, which has a repayment plan in place of a margin loan.

Westpac's new protected equity loan and the Commonwealth Bank's protected loan allow borrowers to set the protection level between 50 per cent and 100 per cent. The lower the protection, the lower the cost of capital protection.

Borrowers can also agree to cap the level of potential capital appreciation at maturity. This will also lower the cost of capital protection.

A Westpac protected equity loan with a three-year term and 100 per cent capital protection has an interest rate of 13.2 per cent. If the investor reduces the capital protection to 70 per cent and caps the capital growth at 120 per cent, the rate falls to 8.7 per cent.

The head of business development for structured investments in the Commonwealth Bank's institutional banking and markets division, Moghseen Jadwat, says a borrower using a Commonwealth Bank protected loan could opt for capital protection of 70 per cent and a cap level of 180 per cent, which is equivalent to a return of 12.5 per cent compounding over a five-year term. The rate on the loan would be 9.8 per cent.

What the jargon means

Interest paid on an investment loan, such as a margin loan, is tax deductible. The borrowed funds must be used to finance the acquisition of an income-producing asset. Shares that produce dividends and managed funds that generate income distributions are examples.

Negative gearing The investment produces a tax loss when the interest cost exceeds the income from the asset. This situation is known as negative gearing. Negative gearing is a strategy for using the tax loss to reduce the tax liability on other income, such as salary.

Prepayments Borrowers can manage the timing of deductions by prepaying interest. If they pay interest due in the 2012-13 financial year before June 30 (which lenders allow them to do), they can claim the deduction against income earned in the current financial year.

Positive gearing If the plan is to be positively geared, so dividends and distributions exceed interest cost, the assets should be in the name of a low-income earner, where possible, to minimise the income tax charged.

Franking credits Investors using a margin loan are eligible for franking credits distributed with company dividends.

Protected loans The Australian Taxation Office does not allow a full deduction for interest payments on protected loans. It divides and allocates some of the interest payment as a non-deductible cost of protection. It is advisable to stick to protected loans that have Australian Tax Office product rulings.