You can borrow money to buy just about anything big or small. You can use a mortgage to buy a home or a credit card to buy a coffee, a home equity loan to build a deck or a student loan to get an education. There are loans available for every purpose.
What about with investing? Can you borrow money to buy a stock? Well yes, most brokerages will lend you money to buy investments. This is called ‘margin lending.’
A margin account is an account offered by brokerages that allows clients to buy securities using money borrowed from the broker. The broker charges interest on the borrowed money and uses the investment as collateral on the loan. Because the loan is backed by a security, it is seen as lower risk than if there is no collateral held against the loan. So the interest rates charged on margin account is generally modest.
The interest rate charged on margin accounts can vary, and it usually depends on how much money you have in your account. Large accounts (those around a million dollars) can have rates that are very low and are comparable to mortgages. Smaller accounts will have rates that are higher, and can be up to 8%.
So how does a margin account work? Let’s look at an example. Let’s start with a trade that does not use a margin account.
Let’s say you have $5,000 to invest. Let’s also say that you love company X, whose shares are trading at $100. So on January 1st, you buy 50 shares of X, using all your $5,000. At the end of the year, X is trading at $150, so you sell all your shares and get $7,500. So over that year you made $2,500 on your investment, or a 50% profit.
Now let’s look at the same trade but using margin this time. Let’s say you still bought those 50 shares at $100. But you love X so much that you borrow $5,000 on margin to buy another 50 shares. Now you own 100 shares of X. Again, at the end of the year you sell all your share, this time 100 of them at $150 thereby getting $15,000 on the sale. Now you have to pay back the $5,000 you borrowed. You’ll also have paid about $300 in interest on the borrowed money over the year. So you’re left with $9,700. On this trade, by using margin, you made a $4,700 for a profit of 94%.
Terrific right!? Well, not so fast.
What happens if your stock goes down? What happens then?
Let’s look at the same trade but instead of going up to $150, X goes down to $50 at the end of the year. Without using margin, you would sell your 50 shares for $2,500. That’s a loss of $2,500 for a net loss of 50%.
Now let’s look at that same scenario using margin. If you sell your 100 shares at $50, you will get $5,000 in proceeds. But you owe your broker the $5,000 that you borrowed, plus the $400 in interest. So not only do you owe your broker all of the money you have in your account, but you would have paid another $400 in interest on the loan! On this trade you lost $5,400 for a net loss of 108%! Ouch!
As you can see, margin can be very dangerous. When your investment goes the wrong way, you can lose a significant amount of money.
The Federal Reserve Board understands this and has put rules in place to prevent excessive loss while using margin. They do this in two ways. The first is by setting an initial minimum margin of 50%. This means that only 50% of your purchase of a stock can be purchased using margin. So in the above example, the trade would be allowed because only 50 of the 100 shares were purchased using margin. It should also be noted that some brokers require higher initial margin requirements, but the legal minimum is 50%.
The second requirement is a maintenance margin of 25%. Maintenance margin refers to the amount of investor’s equity (what the investor owns outright) as a percentage of the market value of the holdings. In our above example, the account would have a maintenance margin of 25% when the stock hit $66.66. When this happens, the value the holdings would be $6,666, but because the investor owes $5,000 for the loan, the actual value of what he owns is only $1,666, or 25% of the balance. When the account value dropped to $6,666, the broker would have contacted the client to ask him to put more money into the account. This is called a margin call. It’s a dreaded occurrence and one every investor who uses margin lending fears.
You should note something interesting here. In the example we used, our investor who used margin and whose stock dropped to $50 would have gotten a margin call when the stock hit $66.66. So although he loses a tremendous amount of money, he is not completely wiped out.
But you should also notice what didn’t happen. The broker didn’t lose money. The margin call made sure that the broker got their loan back. And to make sure they get their money, under the rules of a margin account, the broker can sell your shares without your permission. They have considerable power to get their money back.
So it should be fairly obvious that the margin rules are not there to protect you from excessive loss. They are there to there to protect the broker from any loss.
Now after scaring you out of opening a margin account, there are times when margin is a good thing to have. Borrowing money for very short periods of time is a good way to use margin. For example, if you are waiting for money to transfer into your brokerage account and it isn’t there yet, you can use margin to buy a stock you want. Or sometimes when you sell a stock, it takes a few days for the trade to clear and for the money to reach your account. Again, if you want to use margin for the two days it takes your trade to clear, this is a good use of margin.
But remember, the longer you employ margin, the greater the danger it is to you. Every day you use margin, the more interest you will be charged and the more gains you will need in order for you to make up the interest payments.
So try to keep the use of margin to a minimum, and if you do use it, only do so for very short periods of time.
