Margin debt refers to the funds investors can borrow from a brokerage firm to purchase securities. Margin debt is basically a loan from a broker that must be backed with collateral (cash and other securities), and paid back with interest.
Margin is not available with a cash-only brokerage account, where a trader simply buys the securities they want and cover the full amount using the funds in their account. Margin accounts are available only to investors who qualify, owing to the high-risk nature of margin trading.
Margin Debt Definition
In order to understand what margin debt is and how it works, it helps to review the basics of margin accounts.
What Is a Margin Account?
With a cash brokerage account, an investor can only buy as many investments as they can cover with cash. If an investor has $10,000 in their account, they can buy $10,000 of stock, for example.
A margin account, however, allows qualified investors to borrow funds from the brokerage to purchase securities that are worth more than the cash they have on hand.
In this case, the cash or securities already in the investor’s account act as collateral, which is why the investor can generally borrow no more than the amount they have in cash. If they have $10,000 worth of cash and securities in their account, they can borrow up to another $10,000 (depending on brokerage rules and restrictions), and place a $20,000 trade.
Recommended: What Is Margin Trading?
Margin Debt, Explained
In other words, when engaging in margin trading an investor generally can only borrow up to 50% of the value of the trade they want to place, though an individual brokerage firm has license to impose stricter limits. Although the cash and securities in the account act as collateral for the loan, the broker also charges interest on the loan, which adds to the cost — and to the risk of loss.
Margin debt is high-risk debt. If an investor borrows funds to buy securities, that additional leverage enables them to place much bigger bets in the hope of seeing a profit. The risk is that if the trade moves against them they could lose all the money they borrowed, plus the cash collateral, and they would have to repay the loan to their broker with interest — on top of any brokerage fees and investment costs.
For this reason, among others, margin accounts are considered to be more appropriate for experienced investors, since trading on margin means taking on additional costs and risks. It’s also why only certain investors can open margin accounts.
💡 Quick Tip: When you trade using a margin account, you’re using leverage — i.e. borrowed funds that increase your purchasing power. Remember that whatever you borrow you must repay, with interest.
How Margin Debt Works
Traders can use margin debt for both long and short selling stocks. The Federal Reserve Board’s Regulation T (Reg T) places limitations on the amount that a trader can borrow for margin trades. Currently the limit is 50% of the initial investment the trader makes. This is known as the initial margin.
In addition to federal regulations, brokerages also have their own rules and limitations on margin trades, which tend to be stricter than federal regulations. Brokers and governments place restrictions on margin trades to protect investors and financial institutions from steep losses.
Recommended: Regulation T (Reg T): All You Need to Know
Example of Margin Debt
An investor wants to purchase 2,000 shares of Company ABC for $100 per share. They only want to put down a portion of the $200,000 that this trade would cost. Due to federal regulations, the trader would only be allowed to borrow up to 50% of the initial investment, so $100,000.
In addition to this regulation, the broker might have additional rules. So the trader would need to deposit at least $100,000 into their account in order to enter the trade, and they would be taking on $100,000 in debt. The $100,000 in their account would act as collateral for the loan.
What Is Maintenance Margin?
The broker will also require that the investor keep a certain amount of cash in their account at all times for the duration of the trade: this is known as maintenance margin. Under FINRA rules, the equity in the account must not fall below 25% of the market value of the securities in the account.
If the equity drops below this level, say because the investments have fallen in value, the investor will likely get a margin call from their broker. A margin call is when an investor is required to add cash or forced to sell investments to maintain a certain level of equity in a margin account.
If the investor fails to honor the margin call, meaning they do not add cash or equity into their account, the brokerage can sell the investor’s assets without notice to cover the shortfall.
Managing Interest Payments on Margin Debt
There’s generally no time limit on a margin loan. An investor can keep margin debt and just pay off the margin interest until the stock in which they invested increases to be able to pay off the debt amount.
The brokerage typically takes the interest out of the trader’s account automatically. In order for the investor to earn a profit or break even, the interest rate has to be less than the growth rate of the stock.
Increase your buying power with a margin loan from SoFi.
Borrow against your current investments at just 11%* and start margin trading.
*For full margin details, see terms.
Advantages and Disadvantages of Margin Debt
There are several benefits and drawbacks of using margin debt to purchase securities such as stocks, bonds, mutual funds, or exchange-traded funds (ETFs).
Advantages
• Margin trading allows a trader to purchase more securities than they have the cash for, which can lead to bigger gains.
• Traders can also use margin debt to short sell a stock. They can borrow the stock and sell it, and then buy it back later at a lower price.
• Traders using margin can more easily spread out their available cash into multiple investments.
• Rather than selling stocks, which can trigger taxable events or impact their investing strategy, traders can remain invested and borrow funds for other investments.
Recommended: How to Invest in Stocks
Disadvantages
• Margin trading is risky and can lead to significant losses, making it less suitable for beginner investors.
• The investor has to pay interest on the loan, in addition to any other trading fees, commissions, or other investment costs associated with the trade.
• If a trader’s account falls below the required maintenance margin, let’s say if a stock is very volatile, that will trigger a margin call. In this case the trader will have to deposit more money into their account or sell off some of their holdings.
• Brokers have a right to sell off a trader’s holdings without notifying the trader in order to maintain a certain balance in the trader’s account.
💡 Quick Tip: It’s smart to invest in a range of assets so that you’re not overly reliant on any one company or market to do well. For example, by investing in different sectors you can add diversification to your portfolio, which may help mitigate some risk factors over time.
Is High Margin Debt a Market Indicator?
What is the impact of high margin debt on the stock market, historically? There is an uneasy relationship between margin debt and market performance. Over the years elevated levels of margin debt have been associated with financial instability and market crashes.
For example, the widespread use of margin trading during the 1920s meant that the market was overleveraged, and the excessive reliance on debt contributed to the calamitous stock market crash that led to the Great Depression in the 1930s.
Different Perspectives on Margin Debt Levels
Today, some traders view margin debt as one measure of investor confidence in the markets because investors feel bullish about buying.
However, high margin debt can also be a sign that investors are chasing stocks, creating a cycle that can lead to greater volatility. If investors’ margin accounts decline, it can force brokers to liquidate securities in order to keep a minimum balance in these accounts.
It can be helpful for investors to look at whether total margin debt has been increasing year over year, rather than focusing on current margin debt levels. FINRA publishes total margin debt levels each month.
Jumps in margin debt do not always indicate a coming market drop, but they may be an indication to keep an eye out for additional signs of market shifts.
Recommended: 5 Bullish Indicators for Stocks
The Takeaway
Margin trading and the use of margin debt — i.e. borrowing funds from a broker to purchase securities — can be a useful tool for some investors, but it isn’t recommended for beginners due to the higher risk of using leverage to place trades. Margin debt does allow investors to place bigger trades than they could with cash on hand, but profits are not guaranteed, and steep losses can follow.
Thus using margin debt may not be the best strategy for investors with a low appetite for risk, who should likely look for safer investment strategies.
If you’re an experienced trader and have the risk tolerance to try out trading on margin, consider enabling a SoFi margin account. With a SoFi margin account, experienced investors can take advantage of more investment opportunities, and potentially increase returns. That said, margin trading is a high-risk endeavor, and using margin loans can amplify losses as well as gains.
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*Borrow at 11%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
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