A margin loan allows you to leverage the investments in your account in order to make a larger investment. This is done through your brokerage firm, which lends you money provided you maintain a certain level of equity in your account. However, it’s also a high-risk strategy and not right for every investor.
When you invest in a brokerage account, you’re usually limited to buying securities with the cash in your account (known as a cash account). But there’s another type of account — a margin account — that allows you to borrow money from your broker to invest even more.
Since a margin account comes with higher risk than a typical brokerage transaction, it’s generally only recommended for more experienced investors. In this article, we’ll talk more about what these risks are, how a margin account works, and what you should watch out for.
What is a margin loan?
A margin loan is when you borrow money from your broker using the securities in your brokerage account as collateral. Just like any other type of loan, a margin loan allows you to spend more cash than you have on hand.
Rather than having to sell the securities already in your brokerage account to buy others, you can instead leverage them with the goal of magnifying your return.
Because the brokerage firm is the lender in a margin agreement, each broker can set their own terms. Some terms may include how much you can borrow, how long you can borrow it, the interest rates available, and the types of securities you can purchase on margin.
How do you pay back a margin loan?
Unlike many other types of loans, margin loans don’t have a set repayment schedule. You can keep the loan for as long as you hold onto the securities. Most borrowers repay the loan when they sell the securities they used the loan for.
Can you pay off a margin loan without selling?
Yes, you can pay off your margin loan by depositing additional funds into your brokerage account rather than selling your securities.
Do margin loans show up on a credit report?
A margin loan generally doesn’t appear on your credit report as an open account. However, if you’re issued a margin call and fail to pay back what you owe, your lack of payment may be reported to the credit bureaus and appear on your credit report.
How does buying on margin work?
Buying on margin allows you to purchase stocks, bonds, mutual funds, and other assets by leveraging the securities already in your account to borrow money from your broker. As we mentioned, the terms of a margin agreement will differ depending on the brokerage firm you have your margin account with. Let’s talk about a few characteristics of margin loans.
Margin loan amount
The amount you can borrow on a margin loan depends on the market value of the securities you’re buying and the amount of cash available in your brokerage account. Many brokerage firms allow you to borrow up to 50% of the value of the securities you’re buying.
So, if you had $2,500 in cash or securities in your account, you could purchase up to $5,000 of securities, with you and the broker each funding 50% of the purchase.
Just like any other loan, a margin loan requires that you pay interest on the amount you’ve borrowed. Each brokerage firm sets its own margin rates, but they’re often lower than other types of financing. For example, Fidelity’s margin rates range from 4% to 8.325%, depending on the amount you’re borrowing. Margin loans generally don’t require a set repayment schedule, but monthly interest will accrue as long as the loan remains unpaid.
Just as there’s a requirement for the amount of equity you must have to buy on margin, there’s also a minimum amount of equity. This is known as the maintenance margin, and you must maintain this amount throughout the life of the loan.
The Financial Industry Regulatory Authority (FINRA) requires maintenance margins of at least 25%. However, many brokers require a higher percentage, often around 30 or 40%. If you fall below this percentage of equity, you’ll be hit with a margin call.
A margin call happens when the maintenance margin of an investor’s brokerage account dips below the allowed percentage. At that point, the broker calls back the loan. This means they require that the investor pay back enough to bring their equity back up to the maintenance margin. An investor generally only has a few days to deposit more funds. If they can’t, they must sell some of the securities in the account.
Margin loan example
Suppose you wanted to buy $10,000 of a particular stock, but you don’t want to sell your current holdings to do so. Because you have $5,000 of securities in your brokerage account, you meet the initial margin requirement of 50% and can borrow the other 50% from your broker.
As is normal for the stock market, you notice the value of your securities fluctuates regularly. Your broker requires that you maintain at least 30% equity in the account. This means the securities you used as collateral must hold a value of at least 30% of the amount of securities you purchased. In the above example, you start with an equity of 50% because your initial investment was $5,000.
Suppose the securities you purchased perform as you hoped and their value increases from $10,000 to $12,500. You’ll be able to repay your margin loan, while still maintaining some profit for yourself.
On the other hand, imagine instead that the value of your margined securities falls from $5,000 to $2,500. You’ve dipped below the maintenance margin requirement of 30%, and now have just 25% equity in the account. Your brokerage issues a margin call, requiring that you deposit at least $500 into your account to bring your maintenance margin back up to 30%.
What happens if I don’t meet a margin call?
If you fail to meet a margin call, there could be some dire consequences. First, your broker can sell some of your securities, even without your permission.
In a more severe situation, your broker could sell all of your holdings and take the proceeds of the sale. If that wasn’t enough to pay back your entire margin loan, you would still owe your broker money.
What are the pros and cons of buying on margin?
Buying on margin comes with some key benefits, which is why many investors choose to include it in their investment strategy. However, all investing involves risk, and those risks are even greater for margin accounts. It’s important to understand them before trading on margin.
Here is a list of the benefits and drawbacks to consider.
- Increased buying power. Most brokers require a 50% initial margin, meaning margin trading allows you to literally double the amount of stock you can purchase.
- Amplified returns. Just as buying on margin can increase your buying power, it can also increase your returns. By doubling your investment, you can also double your returns (minus the interest you’ll pay on the loan).
- Flexible loan terms. Unlike many other loans, margin loans don’t have set repayment plans. You can pay back your principal whenever you like as long as you stay above the required maintenance margin.
- Allows for diversification. Buying on margin increases the different assets you have in your portfolio at once, which can reduce your investment risk.
- Amplified losses. Just as margin trading can amplify your returns, it can also amplify your losses if the investment loses money.
- Potential for margin calls. One of the biggest risks of buying on margin is the chance of facing a margin call. It’s important that you don’t borrow so much that you wouldn’t be able to deposit additional funds in the event of a margin call.
- Borrowing costs. Borrowing money is rarely free, and margin loans are no exception. In addition to paying back the amount you borrowed, you’ll also have to pay back interest on the loan.
- Potential liquidation of securities. If your broker issues a margin call and you can’t deposit enough funds, it may sell some or all of your investments, meaning there’s no longer a chance of your assets increasing in value to pay off the loan.
Tips for buying on margin
As we’ve discussed, there are some serious risks to buying on margin. However, many experienced investors prefer margin accounts because of how much they can magnify their returns. If you decide to use a margin loan for a future investment, here are a few tips to help reduce your risk:
- Make interest payments. Accrued interest increases the amount you owe your broker, and if you allow it to pile up, the amount you ultimately owe could be overwhelming. Make regular margin loan interest payments so that when you’re ready to pay back your loan, the amount isn’t as overwhelming.
- Monitor your investments. The last thing you want is to be hit with a margin call when you didn’t even realize your investments had declined in value. Check on your investments regularly so that if you’re nearing the maintenance margin, you can make any preparations needed to deposit more funds into your account.
- Don’t ignore a margin call. Just like any other type of debt, your margin loan doesn’t just go away. If your broker issues a margin call and you ignore it, you could face negative consequences, such as having your investments liquidated by your broker.
If you don’t like the sound of investing borrowed money, a cash account might be better for your interests. Learn more about what a cash account can offer investors right here.
- A margin loan is a loan from your brokerage firm that allows you to buy more securities than you can afford to buy with the cash in your account.
- When you borrow a margin loan, you often use existing securities holdings as collateral. Provided your account covers 50% of the desired assets, you can borrow up to 50% of the purchase price.
- Many brokers require a maintenance margin, which is the amount of equity you’ll need to maintain to avoid a margin call.
- A margin call means the amount of money in your brokerage account fell below the maintenance margin requirements.
- Margin loans can help to amplify your investing profit, but it’s a high-risk strategy because it can also amplify your losses.
Does this sound like the right strategy for you?
Buying on margin isn’t right for everyone. Because of the elevated risk, it’s recommended that you only open a margin account if you’re an experienced investor and will be able to meet margin call if your securities lose value.
If you decide to open a margin account, it’s important to have the right broker by your side. We’ve rounded up the best brokerage firms in our comparison tool so you can see reviews of the companies, the types of assets available, and what their current margin rates are.
View Article Sources
- Investor Bulletin: Understanding Margin Accounts — U.S. Securities and Exchange Commission
- Margin Account — U.S. Securities and Exchange Commission
- Beginner’s Guide to Investing — SuperMoney
- How To Invest In The Stock Market: 8 Basic Concepts — SuperMoney
- Best Online Brokers for Stock Trading in 2022 — SuperMoney
- Best Stock Trading Apps in 2022 — SuperMoney
- Brokerages: Reviews & Comparisons — SuperMoney