Just as you can borrow money against the equity in your home, you can also borrow money against the value of certain investments in your portfolio. This is called margin lending, and it happens within a margin account, which is a type of account you can get at a brokerage.
Most brokerages offer the option of making a taxable account a margin account. Tax-advantaged retirement accounts, such as traditional IRAs or Roth IRAs, generally are not eligible for margin trading.
What is a Margin Account?
When defining a margin account, it helps to understand its counterpart—the cash account. With a cash brokerage account, you can only buy as many investments as you can cover with cash. If you have $10,000 in your account, you can buy $10,000 of stock.
A margin account allows you to borrow from the brokerage to purchase securities that are worth more than the cash you have on hand. In this case, the cash or securities already in your account act as your collateral.
Margin accounts are generally considered to be more appropriate for experienced investors, since trading on margin means taking on additional costs and risks.
How Do Margin Accounts Work?
Once you open a margin account with a brokerage, you’ll be able to purchase securities with a line of credit. The securities and cash you already have in the account act as collateral on the loan, which has an interest rate, just like any other loan. There is no deadline to repay the loan, but most margin accounts require that you keep your account value above a certain threshold. Not all securities can be purchased on margin.
Margin Account Rules and Regulations
When it comes to margin accounts, the Securities and Exchange Commission (SEC), FINRA and other bodies have set some rules:
• Minimum margin: There is a minimum margin requirement before you can start trading on margin. FINRA requires that you deposit the lesser of $2,000 or 100% of the purchase price of the stocks you plan to purchase on margin.
• Initial margin: Your margin buying power has limits—generally you can borrow up to 50% of the cost of the securities you plan to buy. This means, for example, that if you have $10,000 in your margin account, you can effectively purchase up to $20,000 of securities on margin. You would spend $10,000 of your own money and borrow the other 50% from the brokerage. (You can also borrow much less than this.) Your buying power varies, depending on the value of your portfolio on any given day.
• Maintenance margin: Once you’ve bought investments on margin, regulators require that you keep a specific balance in your margin account. Under FINRA rules, your equity in the account must not fall below 25% of the current market value of the securities in the account. If your equity drops below this level, either because you withdrew money or because your investments have fallen in value, you may get a margin call from your brokerage.
Avoiding Margin Calls
As mentioned above, if the equity in your margin account drops below a certain threshold, you may get an alert from your brokerage, called a margin call. This is meant to spur you to either deposit more money into your account or sell some securities to bolster the equity that’s acting as collateral for your margin loan.
Recommended: What is a Margin Call?
It’s worth noting that if your investment value drops quickly or significantly, you may find that your brokerage has sold some of your securities without notifying you. Commonly, investors are forced by a margin call to sell investments at an inopportune time—such as when the investment is priced at less than you paid for it. This is an inherent risk of trading on margin.
What are Margin Costs?
Trading on margin adds additional investment costs. When you borrow money from the brokerage to buy securities, you are essentially taking out a loan, and the brokerage will charge interest. Margin interest rates are different from company to company, and may be somewhat higher than rates on other kinds of loans.
Consider interest costs when you’re thinking about your margin trading plan. If you use margin for long-term investing, interest costs can affect your returns. And holding investments on margin means the value of your securities must hold steady.
What are the Benefits of a Margin Account?
For an experienced investor who enjoys day trading, having a margin account and trading on margin can have some advantages:
• More purchase power. A margin account allows an investor to buy more investments than they could with cash. That might lead to higher returns, since they’re buying more securities and may be able to diversify their investments in different ways.
• A safety net. Just as an emergency fund offers access to cash when you need it, so does a margin account. If you need funds but you don’t want to sell investments at their current price point, you can take a margin loan for short-term cash needs.
• You can leave your losers alone. In another scenario, if you need cash but your investments aren’t doing so well, taking a margin loan allows you to keep your securities where they are instead of selling them right now at a loss.
• No loan repayment schedule. There is no repayment schedule for a margin loan, so you can repay it at any rate you please, as long as your equity in the account maintains the proper threshold. Monthly interest will accrue, however, and be added to your account.
• Potentially deductible interest. There may be tax situations in which the interest in a margin loan can be used to offset taxable income. A tax professional will tell you whether this is a move you can consider.
How Can a Margin Account Make Me Money?
Here is an example of the way in which having a margin account may boost your returns. Imagine that you have $10,000 in a cash account and you buy 50 shares of a stock at $200. Two years later, the stock is worth $250, and you sell your shares for $12,500, realizing $2,500 in gains. (For simplicity, this scenario leaves out trading fees.)
Now imagine if you had $10,000 in a margin account, and you were able to buy 100 shares of the same stock for $20,000, since you could borrow 50% of the purchase price. Two years later, the stock is worth $250, and you sell your shares for $25,000. After paying back the $800 in interest charges (assuming a hypothetical 8% interest rate), you’d realize $4,200 in gains.
What Are the Drawbacks of a Margin Account?
Despite the advantages, using a margin account is risky business. Here are some things to consider before trading on margin:
• You could lose substantially. While it’s possible that trading on margin can help realize greater returns if an investment does well, you will also see greater losses if an investment takes a dive. And even if an investment you’ve purchased on margin loses all of its value, you’ll still owe the margin loan back to the brokerage—plus interest.
• There may be a margin call. If your investments tank, it’s possible that you’ll have to sell securities or deposit additional funds to bring your account back up to the required margin threshold. It’s also possible for a brokerage to sell securities from your account without alerting you.
How Can I Lose Money with a Margin Account?
Here is an example of the way in which a margin account can amplify losses. Using the same example from above, imagine if you used $10,000 to buy 50 shares of a stock worth $200, and over two years the stock price dropped to $100. You would have lost $5,000.
Now imagine if you’d used margin to purchase 100 shares of the stock for $20,000. If the stock price dropped to $100 over two years, you’d have lost $10,000—but you’d still owe the original $10,000 margin loan, leaving you with nothing. Really, less than nothing, since you’d have to pay back the interest as well. It’s ultimately possible for the stock to fall even further, forcing you to come out of pocket for the money you owe the brokerage.
How to Manage Margin Account Risk
If you decide to open a margin account, there are steps you can take to try to minimize the amount of risk you’re taking by leveraging your trading:
• Skip the dodgy investments. Trading on margin works if you’re earning more than you’re paying in margin interest. Speculative investments can be a risky portfolio move, since a swift loss in value can result in a margin call.
• Watch your interest costs. Although there is no formal repayment schedule for a margin loan, you’re still accruing interest and you are responsible for paying it back over time. Regular payments on interest can help you stay on track.
• Maintain some emergency cash. Having a cushion of cash in your margin account gives you a little wiggle room to keep from facing a margin call.
Should You Use a Cash Account or Margin Account?
If you’re a beginner investor, a cash account gives you an opportunity to learn how to trade and invest, and there’s a low level of risk. If you’re a more experienced investor and fully understand the risks of trading on margin, a margin account may offer the opportunity to expand and diversify your investments.
Some financial advisors suggest that clients open margin accounts in case they need cash in a hurry. For instance, if you need money quickly, it takes time to sell investments and for the money to be deposited in your account. If you have a margin account, you can take a margin loan while your securities are being sold. Typically, margin accounts don’t carry any additional fees as long as you aren’t borrowing on margin.
You also need a margin account for short selling. With short selling, you borrow a stock in your brokerage account and sell it for its current price. If the price of the stock falls—which you’re betting will happen—you repurchase shares of the stock and return it to the original owner, pocketing the difference in price.
Like trading on margin, short selling is a strategy for experienced investors and comes with a large amount of risk.
A margin account is an account that lets you borrow against the cash or securities you own, to invest in more securities. As with other lending vehicles, margin accounts do charge interest.
While margin accounts do come with risk—including the risk of losing more money than you originally had, plus interest on what you borrowed—they also offer benefits including more purchasing power and a safety net for short-term cash needs.
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