Margin Account vs. Cash Account: What’s the Difference?
JA
Summary:
Both margin and cash accounts are used to invest money in the stock market. A margin account allows you to borrow money from a brokerage firm to buy more stocks (or other securities) than you could have with your available cash. A cash account, on the other hand, only lets you buy securities using the money you have in the account.
When it comes to investing in the stock market, it’s important to be as informed as possible about the different options available to you. One key decision you’ll need to make is whether to open up a margin or cash account with your brokerage firm. It’s important to understand the difference between the two before opening an account because each type of account has its own benefits and drawbacks. Moreover, knowing the difference between the two can help you make smarter financial decisions and avoid costly mistakes.
In this article, we’ll go through the key concepts you need to know about these two account types so you can make more informed investment decisions.
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What is a margin account?
A margin account is a type of investment account that allows you to borrow money from the broker to buy more securities than you could otherwise afford. This enables you to invest in securities with an amount that exceeds your cash on hand. However, this also comes with a degree of risk because you need to pay back any losses and interest on the margin loan to the broker.
If the value of the securities in the account falls below a certain level, you’re either required to deposit more money or sell some of your investments to cover the loan (more on this below). Conversely, if the value of the securities rises, you get to keep the profits from the sale of the securities.
Although not always a requirement, you will typically need a margin account to invest in:
- Advanced options trades
- Futures trading
- Short selling
- Forex
All in all, margin accounts can be a useful tool for investors who want to take on more risk to potentially earn higher returns. However, it’s important to understand the risks involved before opening one.
Pro Tip
Make sure you understand your broker’s margin trading rules before purchasing any securities on margin. This can prevent you from losing more than the total value of your account.
How do I borrow money to fund my investments?
When you borrow funds from a broker to deposit in your margin account, you do so through a margin loan. While this allows you to leverage your assets and buy more securities, margin loans charge interest and use your investments as collateral. That means your investments must increase and surpass the cost of interest in order to make a profit.
For example, if you took out a margin loan with an interest of 7%, your investments would have to increase by more than 7% before you made a profit.
Keep in mind that margin interest rates vary by the brokerage firm and the amount of the loan. For brokerage firms such as Fidelity and Charles Schwab, you can expect interest rates as low as 4.250% or as high as 8.575%.
Can you buy stocks without margin?
Yes, you can buy stocks without margin. The majority of brokers will provide you with the option to purchase stock on margin by opening up a margin account. However, if you’re averse to leverage-related risks, you can simply decline and buy stocks with your own money.
What are the pros and cons of a margin account?
Benefits of a margin account
Opening up a margin account can have some great financial benefits, especially if you’re a risk-taker.
Leverage
One of the main appeals of opening up a margin account is its ability to magnify your investment returns. This means that you can control a larger position in the market with less capital. For example, if you want to buy $10,000 worth of stocks, but only have $5,000 in your account, you can borrow the other $5,000 from your broker. This allows you to make more money on your investment if the stock goes up.
For example, a 30% increase in the stock would give you a profit of $3,000 (minus interest) if you trade on margin. Whereas with a cash account, you’d only profit $1,500. In other words, with the same initial investment, you’re able to double your returns by taking advantage of leverage from a margin account.
Tax benefits
Another advantage of margin accounts is that the interest on margin loans may be tax deductible against your net investment income using Form 4952. This can help reduce your taxable income and may result in a lower overall tax bill. Be sure to consult a tax professional first to see if this applies to you.
Pro Tip
Sudden price movements can be dangerous when you’re trading on margin. Make sure you minimize your losses when your position moves past a certain point by using stop orders.
Drawbacks of a margin account
While margin accounts can be great for experienced investors, they’re not for everyone.
Higher risk
One of the biggest disadvantages of margin accounts is the high level of risk. When you open a margin account, your broker will lend you up to 50% of the value of your stock purchases and charge interest on that loan. In other words, if you have $10,000 in your account and buy stocks worth $20,000, the broker will loan you $10,000 to cover the difference. This can be a great way to increase your buying power, but it also means you’re risking more money than you have in the account.
Let’s say the stock price falls by 20% in this case. Then your investment will lose $4,000 in value, instead of just $2,000 in value if you traded with a cash account. Moreover, if you’re using leverage during large price swings, the aftermath can be even more disastrous.
Regulatory requirements
There are quite a bit of regulatory requirements from the Federal Reserve Board (FINRA), and the Securities and Exchange Commission when it comes to margin trading. These are the minimum margin, initial margin, and maintenance requirements.
- Minimum margin. Before you can trade, you must meet the “minimum margin” requirement. You can do this by depositing at least $2,000 or 100% of the securities’ purchase price—whichever is less—with your brokerage firm.
- Initial margin. Then, to receive a loan from a brokerage, you’ll need to meet the “initial margin” requirement, which states that you can only borrow up to 50% of the purchase price of the margin securities.
- Maintenance margin. Finally, FINRA rules also require your brokerage to impose a “maintenance requirement” on your account. This means after trading, you must maintain a certain amount of equity in your account at all times. The regulatory minimum is currently set at 25% of the total market value of margin securities. However, some brokerages can set higher maintenance requirements of 30% or even 40%.
Example:
Let’s say you purchase $15,000 worth of securities by borrowing $7,500 and paying $7,500 in cash. If the market value of the securities you purchased drops to $9,000, the equity in your account is now $1,500 ($9,000-$7,500).
If your brokerage has a 25% maintenance requirement, then you must have $2,250 in equity in your account at all times ($9,000 x 0.25). Since your current equity of $1,500 is less than the $2,250 required, you may now run the risk of a margin call.
What is a margin call?
A margin call occurs when you run out of funds in your margin account and you must deposit more. This can be through depositing more cash into your account or liquidating some of your investments. Margin calls often occur because the investor doesn’t have enough money to pay for the maintenance margin.
What is a cash account?
A cash account is a type of brokerage account where you can only use the cash at hand to buy securities. Unlike a margin account, there’s no borrowing allowed, so you can’t use a cash account to purchase shares on margin or conduct short-selling activities.
When you want to buy securities in a cash account, you must first deposit enough cash to pay for the trade, or sell other securities so that cash is available to settle the buy order. Cash accounts usually give you access to a wide range of securities, which is great for diversifying your investment portfolio. Some of these include:
- Stocks
- Mutual finds
- Index funds
- Bonds
- ETFs
- REITs
- Cryptocurrencies
What are the pros and cons of a cash account?
Benefits of a cash account
Cash accounts are preferable for most introductory investors. By only using the money you have in your account, you don’t have to worry about interest payments or losing money you can’t pay back.
Lower risk
Trading on a cash account means you’ll only lose what you put in and won’t be liable for any more losses than that. This means it’s less risky than trading on margin, which involves using borrowed funds and can result in owing the broker money.
Beginner-friendly
For beginner investors, a cash account is more advantageous than margin accounts because it’s far more conservative. With a cash account, you can only buy and sell securities with the money that you have in your account. This prevents you from owing money to your broker if the stock market takes a downturn and your investments lose value. So if you’re still learning how to purchase, sell, and value stocks, a cash account can lower your chances of making unnecessary and costly mistakes.
Drawbacks of a cash account
For investors with a lot of experience or those looking to diversify their portfolios, cash accounts may not be the best choice.
No leverage
The disadvantage of a cash account is that it limits your ability to leverage your investment. For example, let’s say you have $10,000 in a cash account and you want to buy $20,000 worth of stock. You would have to come up with the extra $10,000 yourself.
Cash settlement rules
Another potential downside with a cash account is that it requires funds to be settled before they can be used again, which is a process that can take some time. And since cash trading can only be conducted if your brokerage account has sufficient funds to complete the transaction, you might not be able to trade as frequently as you like.
Can I short sell with a cash account?
No. Unfortunately, you’re not generally allowed to short sell with a cash account. Shorting is essentially to borrow the stock from someone and sell it, which is only possible with a margin account. There is an exception. You can sometimes sell a security in a cash account if the security is held in the account. You may also be able to do it if your broker accepts in good faith a representation that you own the stocks and will be soon deposited in your account.
Should beginners use a margin or cash account?
Many beginning investors wonder whether they should use a margin or cash account. The answer to this question largely depends on your personal investment goals and risk tolerance. A cash account is a more conservative option that allows you to buy stocks with the money you have on hand. A margin account, on the other hand, gives you the ability to borrow money from your broker to buy stocks.
If you’re a beginning investor, using a cash account is generally the best option. This is because buying stocks with borrowed money can be risky. If the stock price falls, you’ll not only lose money on the investment itself, but you’ll also owe money to your broker.
Of course, there are some situations where using a margin account may make sense. For example, if you’re investing for short-term goals and you’re confident that the stock price will rebound quickly, then borrowing money can be a good way to maximize your profits.
In general, though, it’s best to start out with a cash account and only borrow money when you’re comfortable with the risks involved.
Can I change my margin account to a cash account?
It depends on your brokerage firm. Some will allow you to change from a margin account to a cash account or vice versa, but others won’t. Make sure to get in contact with your brokerage through phone or email to find out.
What account is better for my money?
Each account has its benefits and drawbacks, so there’s no one right answer. Generally, experienced investors are likely to get more out of a margin account because of the high rewards. Beginning investors, who probably don’t know how to anticipate changes in the market, are better off with a cash account.
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Key Takeaways
- The key difference between a cash account and a margin account is that investors in a cash account can only purchase securities with the cash they have on hand, while investors in a margin account can borrow money from the broker to buy more securities.
- Even though a margin account provides you with more leverage, it comes with greater risks.
- If the value of your securities falls below a certain level in your margin account, you might run the risk of a margin call.
- You can only short sell with a margin account and not a cash account.
- If you’re a beginner, it’s recommended that you start out with a cash account and only trade on margin once you’re comfortable with the risk involved.
- Cash trading can only be done if your brokerage account has sufficient funds to complete the transaction. And because cash settlement can take some time, this can be an inconvenience to investors who want to trade daily.
Ready to start investing?
Trading on margin can be a great way to make money in a bull market, but it can also lead to big losses in a bear market. A cash account, on the other hand, is much less risky but doesn’t allow you to magnify your profit with leverage.
Regardless of which type of account you want to open—cash or margin—it’s important to find the best match for your needs. Some online brokerages offer commission-free trades on certain stocks, while others offer more robust research tools than others. So it’s always important to compare the benefits of different brokerages before making a decision.
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