Margin loans are back. Banks report that more investors are borrowing to buy shares.

That should be no surprise. Whenever Australian shares do well, higher-income earners, in particular, borrow to invest in shares.

Borrowing to invest in shares always has to be approached with caution. And right now, with the S&P/ASX 200 index at almost 6000 points – the highest it has been in seven years – there are plenty of investors who think the market will continue to trade higher.

There are other factors behind the increase in margin lending besides a strongly-performing sharemarket. Interest rates are at historic lows and term deposits pay less than 3 per cent.

The big banks and Telstra pay dividend yields, after franking credits, of between 6 and 7 per cent. Most fixed rate and variable rate margin loans have interest rates of between 7 and 8 per cent.

Borrowing and trading shares incurs costs in addition to the interest costs of the margin loan. That means many investors are likely to be at least slightly cash-flow negative; that is, the investment in the shares is a loss maker.

They are likely to be “negative geared”. This is where the costs of investing, such as the interest payments, exceed the income from the investment.

The shortfall can be used by the investor to reduce the income tax they pay. That is of benefit most to higher earners who are on the highest rates of marginal income tax.

Of course, there is no point in a loss-making investment unless there are the prospects of capital gains down the track when the shares are sold.

And the capital gains needs to be decent just to recover the losses made on the investment on the way through.

Borrowing to invest in shares can make sense for higher earners where the gearing is conservative.

Financial advisers usually say there needs to be a minimum investment time frame of 10 years. They also usually say they should maximise salary sacrificing contributions into their superannuation first.

Anyone thinking of taking a margin loan should be conscious of the risks. Just as borrowing to invest amplifies the capital gains, it also amplifies the losses. Many investors with margin loans over shares lost plenty during global financial crises. As the value of their shares plummeted, the lenders, to protect themselves, required investors to sell shares or put in some cash to restore the buffer required by lenders.

One of the cardinal rules of investing is that you do not want to become a forced seller. That will be just at the time share prices are plummeting. A margin call can force an investor to realise losses when the investor may have been happy to hold on and ride out the storm.

There were some high-profile disasters involving marging lending after the Australian sharemarket crashed in 2008. These included the collapse of financial planning firm, Storm Financial, where retirees were advised to double-gear into the Australian sharemarket.

The advice was to remortgage their home with a home-equity loan or to borrow against their super and use the money to take out margin loans.

Posted by John Collett – The Age on 4th March, 2015