Will you be paying with cash or credit? Retailers aren’t the only ones asking.
When setting up a discount brokerage account, investors are asked if they’d like to open a cash or margin account, too. But what does that mean?
A margin account amplifies an investor’s buying power by allowing her to borrow money to buy stocks. (In a cash account an investor’s spending is limited to the amount of money deposited.) Through leverage an investor can attain higher gains. On the flip side, margin trading exposes traders to losses that can exceed the amount of cash they have on hand to pay back the loan.
How margin trading works
Let’s say an investor wants to purchase 200 shares of a company that’s currently trading for $30 a share, but she only has $3,000 in her brokerage account. She decides to use that cash to pay for half (100 shares) and she buys the other 100 shares on margin by borrowing $3,000 from her broker.
In a winning scenario, suppose the share price of the stock increases 33% to $40: The $10-per-share profit on 200 shares comes to $2,000. Hats off to the investor: Margin allowed her to pay just 50% of the purchase price of the stock and keep 100% of the profits after she pays back the money she borrowed. By buying shares on margin, the investor got a 66% return on the $3,000 she paid out of pocket.
Margin trading can be risky (and pricey) business for investors without the know-how and financial means to handle the loan.
Not every investment is a winner, however. In a losing scenario, the stock takes a hit and the share price drops from $30 to $20. A 33% loss to an investor paying cash is a 66% loss to the investor who purchased shares on margin. Although she shelled out just $3,000 to purchase the stock she takes a hit for 100% of the $2,000 loss. (Remember, she’s down $1,000 on the initial $3,000 cash investment and another $1,000 on the $3,000 purchased on credit.)
And if the stock price spirals even further to, say, $10 a share? The total investment is now worth just $2,000, but the investor needs $3,000 to pay off the loan. Even after she sells the remaining shares to pay down the loan, she still owes an additional $1,000. That amounts to a total loss of $4,000 (her original $3,000 investment plus an additional $1,000 to satisfy the terms of the loan). Ouch.
Margin loan basics
As the example above illustrates, margin trading can be risky and pricey business for investors without the know-how and financial means to handle the loan. So let’s dive into some of the details of margin loans, starting with a few key components of the loan:
- Like a secured loan, a margin loan requires the investor to provide collateral, which acts like a security deposit. The value of the assets held in an investor’s account — including cash and any investments like stocks and mutual funds — serve as collateral for the loan. At a minimum, most brokers require investors to maintain $2,000 in their account to borrow on margin.
- The credit limit — the amount an investor is allowed to borrow —is based on the price of the asset being purchased and the value of the collateral. Typically a broker will permit an investor to borrow up to 50% of the purchase price of a stock up to whatever the amount in collateral is in the account. Say, for example, you want to purchase $5,000 in shares of a stock and put half of that on margin. You’ll need to have enough cash in the account (aka “initial margin”) to cover $2,500 of the tab to borrow the other $2,500 on margin.
- Like any loan, the borrower is charged interest. The brokerage sets the interest rate for the loan by establishing a base rate and either adding or subtracting a percentage based on the size of the loan. The larger the margin loan, the lower the margin interest rate. To use an example from a major brokerage, in late 2017, an investor who wanted to borrow up to $24,999 would pay an 8.5% interest on the loan, whereas an investor borrowing $100,000 to $249,999 would pay an effective rate of 7%. Interest accrues monthly and is applied to the margin balance. When the asset is sold, proceeds first go to pay down the margin loan.
Although margin loans have some things in common with traditional loans, the devil — and danger — is in the differences.
Maintenance requirements and margin calls
With a traditional loan (a mortgage, for example), the value of the asset purchased with borrowed money has no bearing on the terms of the loan once the paperwork is signed.
If one year home sales in the neighborhood are sluggish and the algorithm on your favorite real estate search engine says that your house is worth less than what you paid for it, that’s merely a paper loss. The bank isn’t going to raise your interest rate or ask you to reapply for a loan. Nor will the lender force you to sell your house, or if you won’t do that, possess your car and sell it for cash.
But if mortgages worked like margin loans, that’s exactly the kind of scenario that a homeowner would face.
Margin loans, unlike mortgages, are tethered at all times to the constantly fluctuating level of cash and securities (the loan’s collateral) in an investor’s brokerage account. To comply with the terms of the margin loan, investors must maintain a minimum level of cash and securities in their account, or the broker’s “maintenance level.”
Margin Trading FYIs
- Margin trading isn’t allowed in retirement accounts, such as an IRA.
- Applying for a margin account may generate a hard inquiry to your credit.
- The Federal Reserve Board does not allow investors to purchase penny stocks, stocks that trade on the over-the-counter bulletin board service or shares of some initial public offerings on margin.
- The maintenance level can vary based on how risky a broker deems the margined stock.
- For some types of trades — notably short selling — investors are required to have a margin account.
If the value of those securities dips and the collateral falls below the maintenance level (as can happen when any of the stocks in the portfolio drop, including the ones purchased on margin), the broker will issue a “margin call.”
At that point an investor has from a few hours to a few days to bring the account value up to the minimum maintenance level. She can do that by depositing more cash or selling equities (or closing option positions) to increase the amount of cash in the account.
Miss the margin call deadline, and the broker will decide which stocks or other investments to liquidate to bring the account in line.
Other perils of margin trading
Does the threat of a margin or maintenance call make you nervous? That’s a perfectly reasonable reaction.
Stock values are constantly fluctuating, putting investors in danger of falling below the maintenance level. As an added risk, a brokerage firm can raise the maintenance requirement at any time without having to provide much notice, according to the fine print of most margin loan agreements.
Regardless of what spurs a margin call or causes an investor’s account to fall short of the minimum maintenance level, margin trading can lead to all sorts of financial jams, including:
- Being forced to lock in losses. If covering a margin call requires you to sell off shares, the opportunity to hold onto a stock to see if it recovers from a loss is off the table.
- Short-term sales that trigger a tax bill. Investors trading in a taxable brokerage account need to consider which shares of what stock they put up for sale to avoid a higher short-term capital gains tax bill. And remember, you don’t have a say in which equities are sold if it’s left to the broker to bring your account in line with its margin requirements. (On the plus side: In some cases interest on margin loans may be tax deductible against your investment income.)
- Loan terms that gut investment gains. As with any debt, the math only works in your favor if the investment you’re making outearns the interest rate you’re paying on the loan. That’s a relatively high bar with margin loan rates in the 7% to 9% range.
- A hit to your credit. Like with a conventional loan, failure to pay back the loan according to the terms of the contract can lead to a negative mark on the borrower’s credit report.
- Exposure to greater losses. As illustrated in the example above, buying on margin can lead to losing more money on a trade than you would have if you stuck with the cash you had on hand.
Handle with care
Margin loans, like credit cards, can be a helpful leveraging tool. For investors who understand the risks and have ample investing experience, margin trading can enhance profits and open up trading opportunities. Just be sure to heed all of the margin loan warnings and don’t get in until you know exactly what you’re getting into.