When opening a brokerage account to invest in securities, investors can choose between a margin account or a cash account. There are reasons for choosing either account, and it’s important for investors to understand them both in order to make the best decision for their own financial goals.
The main difference between the two accounts is that with a margin account an investor can borrow from their broker, whereas with a cash account they can’t.
What is a Cash Account?
A cash account is an account with a brokerage firm that requires investors to purchase securities using the money they have available in their account at the time of settlement. They can’t borrow money from the broker and they can’t take short positions on margin. If they don’t have cash available they can also sell securities in their account to purchase different ones. Investors have two business days to pay for securities they buy with their cash account, according to the Federal Reserve’s Regulation T, also referred to as T+2.
How Does a Cash Account Work?
Cash accounts allow both institutional and retail investors to buy securities using whatever amount of money they put into their account. For instance, if they deposit $3,000 into their account, they can invest in $3,000 worth of securities.
Cash Account Regulations to Be Aware Of
There are several regulations that investors should keep in mind when it comes to cash accounts, pertaining to having enough cash in their account to pay for securities.
Cash Liquidation Violations
Transactions can take a few days to settle, so investors should always sell securities before purchasing new ones if they are using that money for the purchase. If there is not enough cash in the account to pay for a purchase, this is called a “cash liquidation violation.”
Good Faith Violation
This is another regulation to keep in mind. A Good Faith Violation occurs when an investor buys a security, buys another security, then sells it to cover the first purchase when they don’t have enough cash in their account to cover the purchase.
Free Riding Violation
In this type of violation, an investor doesn’t have cash in their account, and they attempt to purchase a security by selling the same security.
Benefit of a Cash Account: Lending
One benefit of cash accounts is that investors can choose to lend out money from their account to hedge funds, short sellers, and other types of investors. The account holder can earn interest or income from lending, known as securities lending or shares lending.
If a cash account holder wants to lend out cash or shares, they can let their broker know, and the broker will provide them with a quote on what borrowers will pay them. Securities that earn the highest interest rates are those in low supply and high demand for borrowers.
These tend to be securities with a lower trading volume or market capitalization. If an investor lends out shares of securities, they can earn interest while continuing to hold the security and earn on it as it increases in value. Account holders may need to meet minimum lending requirements.
What is a Margin Account and How Does It Work?
Using a margin account, an investor can deposit money but they can also borrow money from their broker. This allows investors to use leverage to buy larger amounts of securities than a cash account allows, but if the value of securities goes down, the investor will owe the broker additional money and lose the initial amount of funds they deposited into the account.
Margin accounts also charge interest, so any securities purchased need to increase above the interest amount for the investor to start seeing profits. Different brokers charge different interest rates, so it’s a good idea for investors to compare before choosing an account.
Usually there is no deadline to repay a margin loan, but the debt accrues interest each month, so the longer an investor waits the more they owe. The securities held in the account act as collateral for the margin loan, so if needed they can be used to pay it off.
Other requirements generally associated with margin accounts include:
Investors must deposit a minimum amount of cash into their account before they can start investing and borrowing. Each broker may have a different minimum, but the Financial Industry Regulatory Authority (FINRA) requires investors to have either $2,000 or 100% of the purchase amount of any securities the investor wants to buy on margin, whichever amount is lower.
Usually investors can only borrow up to 50% of the purchase amount of securities they want to buy. For example, if an investor with $3,000 in their account, can borrow $3,000, allowing them to purchase $6,000 worth of securities.
Both before and after purchasing securities, investors must hold a certain amount in their account as collateral. The investor must own at least 25% of the assets (cash or securities) in their account when they have taken out a margin loan. If the amount in the account dips below this level, the investor may receive a margin call, requiring them to either deposit more cash into their account or sell some of their securities. This could occur if the investor withdraws too much from their account or if the value of their investments decreases. This is one of the main risks of margin accounts.
Margin Account vs. Cash Account
There are some similarities between margin accounts and cash accounts, but there are some key differences in terms of the monetary requirements for investors to consider when choosing which type of brokerage account works best for them. The type of account you choose will have an impact on the amount of money you’re able to invest, and the risk level that accompanies it.
The accounts can be equated to a debit card vs. a credit card. A debit card requires the user to have funds available in their account to pay for anything they buy, while a credit card allows a user to spend and pay back the expense later.
Similarities Between Margin and Cash Accounts
Both are brokerage accounts that allow investors to purchase securities, bonds, funds, stocks, and other assets in addition to holding cash. (You typically can’t have a margin account in a retirement account such as an IRA or Roth IRA)
Differences Between Margin and Cash Accounts
Margin accounts allow investors to borrow from their broker and typically require a minimum deposit to get started investing, while cash accounts don’t. However, margin accounts usually don’t come with additional fees.
On the other hand, cash account holders may only purchase securities with cash or settled funds, and cash accounts don’t allow short selling, or ‘shorting’ stocks.
Should You Choose a Margin Account or a Cash Account?
Although being able to borrow money with a margin account has benefits in terms of potential gains, it is also risky. For this reason, cash accounts may be a better choice for beginner investors.
Cash accounts may also be better for long-term investors, since investments in a margin account may go down and force the investor to have to sell some of them or deposit cash to maintain a high enough balance in their account. This could result in an investor being forced to sell a security at a loss and missing its potential price recovery.
With a cash account, the value of securities can rise and fall, and the investor doesn’t have to deposit any additional funds into their account or sell securities at a loss. Investors may also choose a cash account if they want to ‘set it and forget it,’ meaning they invest in securities that they don’t want to keep an eye on all the time since they will never owe the broker more money than they invested.
The risk level on a cash account will always be lower than with a margin account, and there are less risky ways to increase returns than by using margin.
On the other hand, for investors interested in day trading, margin accounts may be a great choice, since they allow the investor to double their purchasing power. They also allow investors to short trade. Margin account holders can borrow money to withdraw to pay for any life expenses that need to be paid off in a rush.
Recommended: What is Margin Trading?
Since there is no deadline to pay off the loan, the investor can pay it back when they can, unless the value of the stocks fall. Traders can also borrow money to buy stocks when the market is down or to prevent paying capital gains taxes, but this requires more experience and market knowledge.
Margin accounts provide flexibility for investors, who can choose to use them in exactly the same way as a cash account.
There are many factors to consider when deciding between a cash account vs margin account. Both margin accounts and cash accounts have benefits and risks for new and experienced traders. If you’re just getting started trading, one simple way to start building a portfolio is using SoFi Invest® brokerage platform.
It lets you research, track, buy, and sell securities right from your phone.
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