Most of you will no doubt feel familiar with the loan process around buying a property. Normally, you would start by finding a property that you may wish to live in or rent out, decide what price you would be willing to pay and purchase it if the seller agrees with your price. If you can't stump up the half mil the property hypothetically costs you (if you're lucky), you would normally head to your nearest bank for a loan against the property, otherwise known as a mortgage (French for 'agreement until death' – fun fact). If you can put up a deposit of at least 10% of the loan, the bank will hopefully take care of the rest.
Most of us who either own or hope to own a house will know all this and it is accepted as the 'normal' thing to do. After all, I would guess that over 95% of properties out there have been bought this way.
What does this have to do with shares?
Good question! If you ask the average investor out there if they have borrowed money to buy shares, you could probably expect anything from a puzzled look to derisive laughter – or maybe the odd nod if you're lucky. Yet most of the major banks such as Commonwealth Bank of Australia (ASX: CBA) offer share loans (usually referred to as margin loans) as part of their brokerage services, where money is lent to purchase shares, and the shares are used as collateral in the loan.
Using loans – otherwise known as leverage or gearing – is far less common with shares than with property. And yet the same principles apply – leverage can amplify your returns as well as your losses on the stock market, just like with property. If you put up $50,000 of your own cash and take out a further $50,000 as a margin loan and buy $100,000 worth of shares in a hot growth stock that doubles in a year, your shares have just gone up 100% – congratulations. But your principle (i.e. the $50k) has increased by 400% – congratulations again.
Of course, if it goes the other way, you lose more than you put in – hard truths cut both ways, after all. If this happens, the bank may call you up and ask for additional cash to shore up the loan (a margin call). If you don't have the cash, the bank will sell your shares. So it's easy to see why leverage is not that popular.
Foolish takeaway
Leveraged margin loans can be an effective vehicle if used conservatively – say with an 80–90% loan-to-value ratio (LVR). This would greatly reduce the risk of a margin call and might help to build wealth in shares at a faster rate (you also have to pick the right ones!). Using debt to invest is a tried-and-true modus operandi of the wealthy, and the interest on the loans may be tax deductible as well. Some Foolish food for thought!
