Equity derivatives provide an opportunity to seek enhanced income returns from share investments, while managing risk and providing portfolio hedging
Like property, you can borrow to invest and build a share portfolio, we examine the benefits and risks of investment lending
When it comes to investment lending, many Australians are familiar with using borrowings to purchase an investment property. Fewer are familiar with the ability to borrow to invest in shares. This article dives into the benefits and risks of borrowing to invest in both asset classes. It highlights the benefit of asset class diversification for those with an existing portfolio and shows how borrowing to invest in shares could be used to save for a new property over time.
Borrowing to invest in property
When you borrow to purchase an investment property the process is straight forward. Investors start with a deposit, which is usually around 20% of the purchase price and they borrow the remaining 80% to purchase the property. They pay interest on the borrowed money and receive rent to help cover part of the borrowed money. Historically, over time, the value of the property grows, and an investor benefits from the capital growth if they sell the property for a profit. There are also potential tax benefits for borrowing to invest.
Of course, buying property in Australia is getting harder for new investors given the prohibitive costs in capital cities and high transaction costs such as stamp duty on the purchase and agent costs when it’s time to sell.
Investment properties also have ongoing maintenance costs and the sale of an investment property can take time. Investors usually wait for a tenant’s lease to end before putting a property on the market. It typically takes weeks to run a sales campaign and settlement usually 6 weeks once a buyer is found. Despite all these factors, investing in property remains extremely popular and understandably so. According to the ABS the long-term return on Australian national residential property has averaged 10.7% p.a since 1926. Even once you remove the costs of purchasing and holding the property you can see why using leverage to invest in property is popular.
The benefit of using leverage to invest in property means is that with a $200k deposit an investor can purchase a property for $1m. Should the property increase by 20% to $1.2m, the original $200k investment will have created a return of $200k, turning a relatively small investment into a big return. Yes, this is overly simplistic and ignores a lot of the costs such as mortgage expenses, stamp duty, agent fees etc but it illustrates the point of why leverage is useful for investments.
There is a risk of course that the property value might decline. Both gains and losses are amplified when you borrow to invest in any asset class.
Investment lending for shares
For investors looking at alternative investments to property, historical data shows the Australian share market has achieved an annual return of 10.9% since 1926¹, a slightly higher return than residential property. Like property, investors also have the ability to borrow to purchase shares and the outcomes are similar to our property example above. As with property, both gains and losses are amplified when you borrow to invest in shares.
In addition to having a similar long-term return, shares offer additional features such as lower transaction costs. For example, brokerage fees can be as little as 0.11% on shares vs approximately 2% for agent’s fees on property. Shares are also more liquid than property as you can sell at any time and settlement generally occurs within 2 days compared to 6 weeks on standard settlement period for property. With shares, there is no need to find a tenant, and many shares offer a dividend yield that is comparable to rental income. In addition, shares may also carry additional benefits of franking credits. There are no ongoing maintenance costs to achieve the returns. You can start with as little as a $20,000 credit limit, so there is no need to save for a big deposit.
Of course, there are some downside risks to consider too. Loans to invest in shares usually carry a higher interest rate compared to loans secured by property. Like property, share investing also carries potential tax benefits such as negative gearing. Approved lending ratios on shares also tend to be lower than they are for property. Depending on the nature of the security loan to value rations (LVR) vary from 40% to 80%. The more liquid security chosen, the higher the LVR.
Understanding investment lending market risk
While long term returns on Australian shares are similar to the returns on residential property, over shorter periods of time, share values tend to be more volatile than property. And remember, using leverage can amplify both gains and losses.
The ability for investors to sell their shares anytime during trading hours is a double edge sword because it means the value of the shares is constantly changing. This may not be for everyone and it can lead to additional risks when borrowing to invest, such as margin calls.
A margin call occurs when the value of the shares falls so that The LVR exceeds the maximum amount permitted under the terms and conditions. In these situations, the lender may ask for extra security for the loan or for the loan to be paid down to return to the maximum amount permitted. If an investor fails to do this, the lender may sell some of the security to recover the loan.
To help reduce the risk of a margin call investors can choose to borrow less than the maximum LVR and increase diversification by holding more than one type of share or securities within the portfolio.
For investors who want to borrow to invest in ETFs without the risk of a margin call, they may consider NAB Equity Builder which offers many of the benefits of leverage, while removing the risk of margin calls.
Borrowing to invest in shares may appeal to different types of investors, from those seeking investment portfolio growth, to those who already hold an investment portfolio and are looking to diversify. Borrowing to invest in property and shares carry different risks and benefits and investors must do their research before investing.
The information contained in this article is gathered from multiple sources believed to be reliable as of the end of September 2023 and is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, we recommend that you consider whether it is appropriate for your circumstances and that you seek independent legal, financial and taxation advice before acting on any of this information. Credit applications are subject to credit assessment criteria. Interest rates, fees and charges are subject to change. Target Market Determinations for our products are available at https://www.nab.com.au/important-information/target-market-determinations. Products issued by NAB unless stated otherwise. ©2023 NAB Private Wealth is a division of National Australia Bank Limited ABN 12 004 044 937 AFSL and Australian Credit Licence 230686.
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