What Is a Margin Loan?
A margin loan is a loan from your brokerage to pay for securities that you can’t cover with cash. Similar to any other loan, you must apply for the account and be approved before you can borrow funds; and your brokerage will charge interest on any funds you borrow.
Having a margin account by definition enables you to take out a margin loan (the two are synonymous in many ways). Having the flexibility to buy securities on margin gives many traders the ability to take positions they might not have been able to afford otherwise. In fact, margin loans are a cornerstone to putting together effective day trading strategies, for advanced investors.
So, just what is a margin loan and how does it work?
Understanding Margin Loans
Understanding margin trading can be tricky, but for the average investor, all you really need to know is that a margin loan is essentially a short-term financing solution. If you want to buy securities, but don’t have the cash in your account, your brokerage may allow you to buy those securities using credit. It’s similar to a line of credit, in that way.
So, that’s what margin debt is: The result of a margin loan, in which a trader borrows money to buy securities.
How Margin Loans Work
While we’ve mostly been discussing margin loans in terms of trading and investing, they could be used for any purpose. But almost always, a margin loan is used to buy securities.
As for the process of how they actually work: A margin loan is more or less like any other loan. To get one, you’ll need to apply and qualify for margin on your brokerage account (typically called a “margin account”).
Recommended: What Is a Brokerage Account?
Margin Accounts and How They Work
Like other forms of lending, margin loans have strict criteria. In addition, these accounts are governed by industry regulations as well as the policies of individual institutions, so be sure to understand how your desired margin account works. Each brokerage has different rules and eligibility requirements, and FINRA, for example, also requires you to deposit a minimum of $2,000 or 100% of the security’s purchase price, whichever is less. This is the “minimum margin.” Some firms may require you to deposit more than $2,000.
If you’re approved for a margin account, you’re able to trade using a margin loan — up to a certain amount. According to Regulation T of the Federal Reserve Board, you may borrow up to 50% of the purchase price of securities that can be purchased on margin. This is known as the “initial margin.” Some firms require you to deposit more than 50 percent of the purchase price. (Also be aware that not all securities can be purchased on margin. Only those deemed “marginable” can be traded on margin.)
If you have $5,000 in your brokerage account, and you want to buy Stock X, which is valued at $50 per share, with a 50% margin you could buy 50% more than your cash balance: 200 shares instead of 100. But half of those (100 shares) would’ve been purchased on margin — so, you’d need to settle up your account at some point, if or when you decide to sell your shares (hopefully for a profit).
How Margin Interest Works
The other important thing to remember about margin loans is that they are, like pretty much all loans, subject to interest charges. Your brokerage is going to charge you for the money you borrow.
Margin interest is a big topic unto itself, but the key takeaway is to know that you’ll be on the hook for paying your brokerage back for the money you borrow, plus interest charges.
You’re probably thinking: “Can I avoid paying margin interest?” The answer is that it depends on how fast you can pay your margin balance back. Most brokerages will charge interest by the day and add the charges to your account monthly. So, if you have cash or can sell securities and pay your balance off before interest accrues, it’s possible.
Margin Loan Pros and Cons
Marginal loans can be highly useful for traders and investors. But like almost any financial instrument, margin loans have their pros and cons.
The biggest upside of margin is that it can open up a new swath of investing choices for traders. That means increasing their buying power, and allowing them to buy securities that may have otherwise been too expensive. This can increase potential profitability, too.
Conversely, traders who aren’t careful can’t quickly find themselves in debt if one of their trades backfires.
There are also interest charges to consider, as discussed. And if things really go sideways, some traders may experience a “margin call,” which is when your brokerage sells your assets without warning to settle up or get your account balance back within its requirements.
Here’s a quick rundown:
Margin Loans: Pros & Cons
|Increased trading capacity||Traders can accumulate debt|
|Traders can buy pricier securities||Interest charges|
|Increased potential gains||Potential margin calls|
Typical Margin Loan Rates
Margin loan rates, or, the interest rate charged by a brokerage for using margin, vary. Brokerages make the information available to traders and investors, so finding what types of margin loan rates you’re subjected to usually just requires a little research (or a call to your broker).
As mentioned, a brokerage will probably charge different interest rates depending on your overall margin balance, and how much you’ve borrowed. Lower balances are typically charged higher interest rates.
Here are some hypothetical examples: Let’s say Brokerage ABC’s margin interest rates vary between 4% and 8%, depending on the trader’s balance. Traders using up to $24,999 in margin will be subject to the highest interest rate (8%), whereas traders with more than $1 million in margin debit are subject to the 4% rate.
Brokerage B, however, has a different scale, with traders in margin debt up to $24,999 subject to 8.5% interest, and those with balances between $500,000 and $999,999 subject to 6.5%.
So, while brokerages do vary in what they charge for margin loan rates, they tend to be similar. To know your exact rate, contact your brokerage, or look up the current rate schedule on the company’s website.
Margin loans are similar to any other type of loan, but are typically used for the purpose of buying stocks or other securities. Once you’ve applied for and been approved for a margin account, which is akin to adding a line of credit to your existing brokerage account, you’ll have the flexibility to buy more investments than if you were relying only on cash.
That said, you’re on the hook for repaying the money you’ve borrowed, with interest. If you’ve made a profitable investment, this shouldn’t be a problem. But if you invest in Stock X on margin, say, and the price drops, you would still owe the full amount you’d borrowed to buy the stock, plus interest.
To start investing, though, you don’t need a margin account. You can open a SoFi Invest® online brokerage account and start buying and selling stocks, ETFs, even cryptocurrency today. SoFi doesn’t charge management fees, and SoFi members have access to complimentary financial advice from professionals.
Photo credit: iStock/Sergey Nazarov
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