"Tis money that begets money", or so the old English proverb goes. They probably didn't have margin loans in the 16th century, but they had the right idea about needing to have money to make money.

Putting to use more money than you actually have - and using it for your own investment ends - is the basic idea behind a margin loan, and it's an attractive concept to many.

The Reserve Bank says that at the end of December last year (its most recent statistics), Australians had borrowed about $9.9 billion on margin loans, and another $800 million under protected equity loans.

Investing with a margin loan involves putting a sum of your own money together with a sum borrowed from a margin lender (usually a bank, but sometimes a specialist lending organisation), and investing the combined amount.

When you buy shares or managed funds with a margin loan, all the dividends and distributions flow through to you as normal, along with any tax benefits (franking credits, for example, in the case of shares).

It works exactly as if the full amount had been your own in the first place. It can multiply your returns, and accelerate the process of creating wealth. But the flipside is that if it goes wrong it can also magnify your losses.

There's also a cost associated with borrowing. The interest rate charged by margin lenders is about 7.6 per cent a year at the moment. But the interest expense associated with margin loans is generally tax-deductible for individuals. The value of a margin lending strategy is illustrated in an example given by Macquarie Bank.

Woolworths shares were worth $5.13 each on December 31, 1996, and by December 31, 2001, the share price had risen to $11.24. During this period, Woolworths paid dividends of $1.01 per share. If an investor put $50,000 of his or her own money into Woolworths shares at the end of 1996, then by the end of the period they would have had shares worth $109,552 and received dividends of $9844, for a total value of $119,396. That's a handsome return, but if the same investor had borrowed, even conservatively, to invest, the result would have been even better. Had they borrowed $50,000 to add to the $50,000 of their own, the portfolio would have grown to $219,103 by the end of the period.

In addition, they'd have received $19,688 in dividends.

After repaying the $50,000 loan, and borrowing costs of $21,412 over the period, the value of their investment would have been $167,380. In other words, the margin lending strategy was worth almost $48,000 over five years.

Usually the reason a margin loan causes problems is because the investor has borrowed too much money, or because the shares or managed funds they have bought with the borrowed money fall in value, and trigger what's known as a "margin call". The "margin" in the margin loan refers to the difference between how much you've borrowed and the total value of the investment portfolio. The margin has to remain intact, and lenders keep a very close eye on it. A margin call occurs whenever the gap between the amount you've borrowed and the total value of the investment becomes too small.

Margin lenders will set limits on how much they will lend against a particular stock. In the case of AMP, for example, a lender may be prepared to let you borrow up to 70 per cent of the value of the AMP shares. This is known as the loan-to-valuation ratio (LVR). If the price of the AMP shares falls, the loan will account for a greater proportion of the value of the shares. If the amount of the loan, expressed as a percentage of the value of the portfolio, exceeds the LVR - in this case, 70 per cent - the lender will issue a margin call.

This is, in effect, a demand to pay back borrowings to restore the margin between the amount you've borrowed and the value of the assets. Figures from the Reserve Bank show that in the December quarter of 2002 there were, on average, 3.5 margin calls per 1000 borrowers being issued every day. There were 125,700 people with margin loans, so there were about 440 margin calls being issued daily, up from 135 a day in the March quarter of 2002, and 266 a day in the June quarter of that year.

When you receive a margin call there are a couple of ways to respond. You can find some extra cash (or sell some shares, and use the proceeds) and pay it to the margin lender, which effectively reduces the size of the loan. Or you can provide additional security, which can mean putting up additional shares or managed funds.

There have been some horror stories in recent weeks concerning the number of margin calls being issued by lenders to borrowers. The threat of war and some disappointing profit results have seen share prices fall so far and so quickly that borrowers have been asked to tip in some extra cash or, worse, sell shares after they've fallen in value.

Andrew Black, head of margin lending at St George Bank, says investors can reduce the likelihood of being hit with a margin call by borrowing conservatively in the first place. But, he says, it is also wise to have a plan for how to deal with a margin call even before investing. "Have a cash reserve," Black says. "There are a lot of people who do that. As part of a good financial plan you would have a cash reserve. And don't borrow right up to the maximum amount."

Investors can't control how far or how quickly share prices move up or down. But there are things that can be done before money is invested, which will make an investor's life less stressful. Philip Moore, principal of Kinvale Financial Planners, based in Newcastle, NSW, says the first step is to determine whether an investor's circumstances and temperament are suited to margin lending.

"The jargon is their 'risk profile'," Moore says. "That is, looking at how old they are, and what level of risk they are comfortable with. Their tax rate has a lot to do with it. Margin lending is generally applicable on the top marginal tax rate, which is more than $60,000 a year income. And their time frame - if they are one year out from retirement, they are not going to have enough income going forward.

"It's really only applicable to aggressive investors - you have to gear into growth assets, not income assets."

Moore says even investors on a high income aren't necessarily well suited to margin lending. "There has to be surplus income," he says. "So if someone is on a high income but they are spending it all on house [mortgage] repayments, it's not applicable."

Margin lending is nevertheless a popular way of investing.

The Reserve Bank says the average margin or protected equity loan was just more than $86,000, as at December 31. Using the Reserve Bank figures, it appears that the average borrower has borrowed $86,000 but has a portfolio valued at almost $163,000. That translates to an average borrowing level of about 53 per cent. It's a relatively conservative level when you consider that some lenders are willing to let investors borrow as much as 80 per cent. But it's an average, and some borrowers may have a far higher level of debt relative to the value of the assets they have bought.

St George's Black says investors who set up a margin lending facility after first talking to an adviser generally have a lower level of borrowing than investors who set up their own facilities. Most of St George's lending is done in conjunction with intermediaries, he says. The average borrowings by St George customers are about 43 per cent of the total value of the investments bought. Scott Young, head of margin lending for Macquarie Bank, says the LVRs allowed by the bank vary from stock to stock, from 40 per cent to 75 per cent. "So, if you took an average portfolio we would have about 65 per cent across the book. It's fairly conservatively geared - it's about two-thirds of capacity, if you want to put it that way.

"You can't say our book is highly geared, but when you get stocks like Telstra and Brambles and some of the banks under pressure, you get margin calls.

"And Aristocrat - that's a typical market response to bad news. If a company doesn't make its forecasts or has any amount of bad news, it has a real impact on the price because the market isn't prepared to support companies that don't forecast accurately. Market sentiment is incredibly powerful."

Deciding ahead of time how to deal with a margin call is important. If it's necessary to sell shares to raise money, for example, the best ones to sell can be identified nice and early, and sold in an orderly fashion.

But investors ought not to receive margin calls out of the blue anyway, says Kinvale's Moore.

Margin loans have what's known as a "buffer", which is an amount over and above the maximum amount the lender is prepared to lend on a particular share or managed fund. An investor may move past the maximum LVR and then use the buffer to manage their debt down again.

"It just means you aren't in and out of margin call as the market moves," Macquarie's Young says. "It allows a period when people can get prepared for margin calls."

Moore says that when markets are uncertain, instalment gearing is an attractive alternative to investing everything in one go. It's a strategy that involves putting up a relatively small amount every month, borrowing a similar amount, and investing the combined amount in the market. It's not some magical way of avoiding losses when markets are falling, but Moore says clients of his who have instalment geared into managed funds are showing smaller losses than investors who have invested a lump sum into the sharemarket.

He says another strategy, which best suits investors who have used a margin loan to buy managed funds through a master trust or wrap account, is to switch between funds to delay or avoid margin calls. "It means that if you're in buffer, I can look at a client's managed fund portfolio, and say they are in an international fund with an LVR of 65 per cent, switch them into a property fund with an LVR of 70 to 75 per cent, and get them out of buffer," Moore says.

Cash funds have an even higher LVR - typically 95 per cent. Choosing the shares or funds to invest in isn't getting any easier but setting up a margin loan is. St George Bank, for example, has an online application service that it says takes about 10 to 15 minutes to complete. It then takes only seconds for the application to be transmitted to St George, approved, and notification sent back to the investor or adviser.

Ironically, with the sharemarket having fallen a considerable way and some top-quality stocks beginning to offer very attractive yields (dividend income), margin lending has until recently not been as popular with investors as a year ago.

It seems that opportunities to buy good-quality shares at attractive prices are proving too tempting to resist.

Macquarie Bank's Young says there's "a really strong correlation between the All Ordinaries index and applications for margin lending".

"We have seen lending coming off since mid-year, and applications for margin lending have been slowing," he says. "The interesting thing is that was the case until mid-February, when we saw applications for margin lending double from what they had been in the previous month. January was the last of the months when it declined."

Young says the levels of margin lending business that Macquarie wrote in January were perhaps only 25 per cent of the levels of 12 months earlier. Offsetting the decline in margin lending, however, was an increase in protected lending. "In January and February we continued to see increases," Young says. "We're doing about three times the volume that we were doing last year. It's traditionally a quiet period in January and February, but protected lending volumes have been quite strong. I think there's an increasing interest in and acceptance of protected lending, particularly in uncertain times, and times of increased volatility.

"So I think there's a preference for protected lending in that sort of climate. We're seeing that in the way people are holding back from margin lending, and are prepared to pay that premium for 100 per cent protection and the ability to sleep at night, not having to worry about margin calls. These things come to the fore in this climate. The interest rate appears expensive, but on an after-tax basis, 3 to 4 per cent is a reasonably acceptable cost when you are looking at a five-year investment. There are a lot of advisers who are supporting a protected lending strategy."

Margin lenders have helped borrowers by increasing the LVRs on some key stocks. In effect, this means that for existing borrowers, the share prices of the stocks in question can fall further before a margin call is triggered. For new borrowers it means a more aggressive borrowing strategy can be adopted from the outset.

"We have increased the LVRs on the major banks and Telstra to 75 per cent, so there's a trend towards larger LVRs," Young says.

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