Trading on margin can increase an investor’s purchasing power and potentially, their returns. Trading on margin simply means investing with money borrowed from a brokerage in order to buy more shares than you might otherwise be able. Investors must pay back the borrowed funds with interest just as they would any other loans. Margin rates determine the cost of borrowing for the investor.
A margin rate is the interest rate that applies when investors trade on margin. Margin rates can vary from one brokerage to the next, and there are different factors that affect the rates brokerages charge. Many brokerages use a tiered rate schedule based on the amount of the margin loan.
While trading on margin can benefit investors by providing them with additional capital, it can also be riskier than regular online stock trading. That’s because if you invest on margin and the investment loses money, you’re out not only the investment losses but also the interest on the money you borrowed. Before opening a margin account, it helps to understand the basic margin rate definition.
Understanding Margin Rates
A margin rate is an interest rate or premium that applies to margin accounts with a brokerage.
It helps to start with an overview of how margin accounts work to understand margin rates. Margin accounts allow investors to purchase securities using borrowed money. Under Federal Reserve Board Regulation T , brokerage firms must cap the amount investors can borrow up to 50% of the securities’ purchase price. This is called the initial margin.
Investors must also meet maintenance margin requirements in their margin account. Specifically, an investor’s equity can’t fall below 25% of the current market value of the securities held in the account.
If an investor fails to meet maintenance margin guidelines, they may be subject to a margin call. A margin call is when the brokerage requires the investor to deposit more money into their margin account in order to make additional trades.
Investors may use margin to trade options, individual stocks, or other securities.
Brokerage firms charge margin rates, the same way a bank might charge interest on a mortgage or a business loan. Interest is a form of risk management, in the event that a borrower defaults.
How Margin Rates Work
Margin rates represent the cost of borrowing for an investor for an outstanding margin loan. Each brokerage can set the margin rate differently, it typically reflects the current broker call rate or call money rate. This is the rate that the bank charges the broker for the money used to fund investors’ margin loans.
Brokerages can establish a base rate, then add or subtract percentage points from that margin rate based on the margin balance. The higher the balance in a margin account, the lower the likely margin rate. So the more you borrow from the brokerage, the less you’ll pay in interest for it, as a percentage of the balance.
Factors That Affect Margin Rate
There are a variety of factors that can determine what a brokerage charges for margin rates.
Broker Call Rate
This is the rate that brokerages pay to borrow the money used to fund margin loans. The higher this rate is, the higher the base margin rate may be.
Supply and Demand
Increased demand for margin loans could result in brokerages charging higher margin rates, both to manage risk on those loans and to reap higher profits.
Inflation and Monetary Policy
Margin rates reflect broader interest rates. If banks begin charging brokers higher interest rates, they’ll pass those on to investors.
Maintaining a higher balance on margin could result in a lower margin rate if the brokerage discounts rates for clients who invest more.
How Can Margin Rates Affect You?
Margin rates can determine your total net profit when trading securities on margin. So assume, for example, that you open a margin account. You want to purchase $10,000 worth of securities of which $5,000 is borrowed money.
You take out a margin loan to purchase the stocks. Those same stocks increase in value, so your $10,000 investment ($5,000 of your own money + $5,000 margin) is now worth $15,000.
You sell the stocks and repay the $5,000 you initially borrowed. You also pay $500 in interest to the brokerage for the margin loan. Once you subtract your initial $5,000 investment, the total net profit to you is $4,500.
Now, how do margin rates affect you if your investment doesn’t pan out? Going back to the previous example, say those stocks drop in value to $6,000 rather than increasing. You sell them for that amount, then pay back the $5,000 you borrowed on margin. You also have to pay $500 in interest. If you subtract those amounts from your initial $5,000 investment, you’re now left with only $500.
Understanding margin rates — and the risks involved in margin trading — can help you decide if it’s an investment strategy worth pursuing, based on your risk tolerance and goals.
When Is Margin Rate Charged?
Margin rates are accrued daily and charged on a monthly basis. So as soon as you purchase securities on margin, the margin rate applies and begins accruing. The total amount of margin interest paid depends on how much you borrow from the brokerage, the margin rate and how long it takes you to pay the loan back.
Generally speaking, traders use margins for short-term trading purposes. Though there’s no set end date for margin loans, the longer you take to pay them off, the more interest you’ll pay in total.
How Is Margin Rate Calculated?
Unlike other loans, margin loans typically do not have a set end date. Interest charges accrue monthly. To find the annual interest rate on a margin loan, you’d multiply the margin rate by the principal amount. To find the daily rate, you’d divide that amount by 360 days.
So assume that you have a $100,000 margin loan with a 6.825% margin rate, which is a common margin rate figure at top brokerages. Your yearly interest charges would add up to $6,825. If you divide that by 360, your daily interest charge breaks down to $18.96. If you were to pay your margin loan off in 10 days, you’d pay a total of $189.60 in interest.
Determining how much you’ll pay for a margin loan is relatively easy if you know the margin rates that apply and have an idea of how long it’ll take you to pay it back. At the very least, you can figure out the daily interest charge and use that as a guide for calculating your total profits on a margin trade.
Margin trading is a more advanced investing strategy that requires some consideration of risk and an understanding of market trends. If you’re just getting started with online stock trading and investing, then you may want to get a feel for how stocks work first before opening a margin account.
SoFi Invest makes it attainable to start trading stocks, exchange-traded funds, cryptocurrency and IPOs online. If you’re ready to start building a portfolio, take the next step and open a brokerage account on the SoFi Invest investment app today.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.