Protected equity loans are “flavour of the month” – but could they leave a bad taste in your mouth?

When you start an investment program, unless you have substantial capital available, you may need to borrow to invest. Borrowing to invest has advantages: you can increase the potential profits on the sale of the investment, and the expenses of borrowing, including interest on the loan, are usually tax-deductible.

It is straightforward to borrow to invest in property. You can usually borrow up to 70% of the purchase price of the property and pay back the loan over a long period of time. However, borrowing to invest in shares and managed funds is different. These investments are volatile and share markets sometimes crash – the latest crash is still affecting the market.

Margin loans for share investments require careful monitoring, especially when markets are unstable. Wise investors will have substantial buffers built into their loan to minimise the potential for margin calls. Some advisers suggest borrowing no more than 50% of the cost of the share portfolio.

Protected equity loans or PELs have been available for a number of years and appear to offer a way of limiting market risk. A PEL is set up to purchase shares and the cost of a ‘put option’ to protect against capital loss is built into the loan.

A put option is a contract between two parties in which the person selling the option agrees to buy a parcel of shares from the option buyer at a specific price during a specific period of time. If the option to sell the shares is not exercised by the buyer during that period, the option lapses. Because the option costs a fraction of the price of the underlying parcel of shares, allowing it to lapse does not cause much financial pain.

Buying a put option at the same time as buying the underlying shares protects against any fall in the price of the underlying shares because there is a guaranteed buyer of the shares at the specified price – also known as the strike price.

Promoters of PELs will often lend up to 100% of the amount required to buy the initial parcel of shares at a fixed rate payable in advance. You may use your own stockbroker to make the purchase from a shortlist of acceptable shares. All dividends, franking credits and capital gains are yours, and options available to you at the end of the term of the loan vary from lender to lender. PELs are marketed as having no margin calls, although the small print will often set down some circumstances in which a margin call may be necessary.

There are a number of rulings from the Australian Taxation Office regarding the tax deductibility of the interest on the loan. If the amount payable in advance includes the cost of the put option, Division 247 of the Income Tax Assessment Act restricts deductibility of interest to a benchmark rate. In the 2010 /11 federal budget it was announced that the benchmark would be the Reserve Bank of Australia’s Indicator Rate for Standard Variable Housing Loans plus 1%.

This is where the use of a PEL can leave a bad taste in your mouth. The interest rate payable is likely to be more than the rate set down in legislation. The cost of the put option is in addition to the interest payable and is not tax-deductible.

It is important to look carefully at the real cost of a PEL to work out what you would need to earn to profit from investing in one. In many cases, a close examination will show that the returns in dividends and capital gains are unlikely to outweigh the cost of investment. Speak to your adviser before investing in a PEL to ensure that it meets your needs and matches your risk profile.

Sources: – www.treasury.gov.au  – “Explanatory Memorandum – Changes to the Taxation of Capital Protected Borrowings” 11 May 2010