Learn about margin accounts and how you can incorporate margin trading into your investing strategy.
A margin account is a kind of brokerage account that allows you to borrow money from the brokerage to buy securities. The broker is willing to lend the investor money based on how much equity — the total net assets (or collateral) — is in the account. It’s a quick and easy way for investors to access money to make an investment, and it can help (or hurt) returns.
Here’s what a margin account is, why some investors use margin, and what it costs.
A margin account is like a brokerage account with a credit card attached. A basic brokerage account is called a cash account. You can buy securities up to the amount of cash that you have in the account. Try to purchase more than you have money for, and the trade won’t go through.
But a margin account allows you to buy more than your cash stash allows. When you buy stock and don’t have enough cash, any deficit is simply borrowed from your margin account. For example, if you purchased $5,000 in stock but had only $4,000 cash, the brokerage would seamlessly borrow $1,000 and add that borrowing to your running margin tab.
If you’re opening a margin position, the brokerage requires you to have at least 50% of the purchase price as equity.
Here’s what makes a margin loan better than a credit card, though. As long as you have enough equity in your account, there are no minimum monthly payments on a margin loan. You can hold a margin loan indefinitely, though it will accrue interest, which will be added to the margin loan. However, margin interest rates are usually much less than what you would pay on your cards.
You can add margin capability when you open a brokerage account. But if you’ve already opened a cash account and want to add margin to it, an email to the brokerage can set it up.
Why do investors want a margin account?
Margin accounts make buying securities much easier, especially when markets move quickly and you want to make a trade today and not wait for cash to arrive in your account. But there’s a much bigger reason that investors use margin — it has the power to compound your returns.
Here’s how that works. Imagine buying 100 shares of XYZ stock trading at $50 a share in a cash account. The stock runs to $70 per share, so you’ve made a profit of $20 per share, or $2,000 in total. That’s not bad, but in a margin account, your profit zooms even higher.
In this case, imagine you have only $2,500 in cash, and you buy 100 shares of the same stock at $50 per share, taking on margin of $2,500 to do so. When the stock runs to $70, your stock is worth $7,000, but you still owe the brokerage $2,500. After subtracting that margin loan, you’re left with a profit of $4,500, not including any interest payments.
That’s why investors (and stock gamblers) use margin. But while margin juices returns, it can hurt them just as easily if a stock falls. Margin cuts both ways.
Take the same scenario as above, but now imagine what happens when the stock falls from $50 to $30. The investor using only cash suffers a loss of $2,000 but still has $3,000 left in the account. Tough break, but the investor lives to fight another day.
But the investor using a margin loan of $2,500 will be nearly wiped out. The total value of the stock declines from $5,000 to $3,000, but the investor still owes the brokerage $2,500. That means the account now has only $500 remaining in it.
So margin magnifies gains and losses, and smart investors use it prudently. For example, many investors use margin to buy a stock when they know money is already coming into the account from a pre-arranged transfer. So it’s more like a credit card that you pay off every month.
How much can you borrow in your margin account?
What you can borrow on margin depends a lot on the individual broker, but to get started brokers generally require you to have $2,000 in equity in order to open and maintain a margin account. The broker wants this much “cushion” to protect itself if your account value falls.
The sky’s the limit on credit — if you have the equity in the account. The brokerage is willing to lend you as much money as it thinks you’re able to assume comfortably.
If you’re opening a margin position, the brokerage requires you to have at least 50% of the purchase price as equity. So if you’re buying $5,000 in stock, you’ll need at least $2,500 in equity.
It’s a different situation once you’ve established the position. To maintain the margin position, however, brokerages usually require a lower percentage of equity in the account. The legal minimum is 25%, though the brokerage may require more, especially if the account has more risky securities, such as small-cap stocks, options, or others deemed riskier by the brokerage.
If you fall below this maintenance margin, the brokerage will quickly let you know and issue what’s called a “margin call.” That’s a situation that no investor wants to find themselves in.
What if you don’t have enough money in your margin account?
When an account falls below the maintenance margin, the investor has to put up more equity in the account, either as cash or securities, until the account exceeds the maintenance threshold. If the investor fails to do this in a timely manner — in a few days or less usually — or the value of the account continues to fall, the brokerage will begin liquidating positions. The brokerage will continue selling until the account has sufficient equity, and any position may be sold.
To get rid of the margin call and maintain their positions, investors must deposit more cash or other securities into the account. Alternatively, investors could sell some securities until the account has sufficient equity. If the equity rises because the securities rise, then the margin call may be resolved with no further action, but it’s unlikely that this happens in time.
How much does a margin account cost?
Margin accounts don’t cost anything, and many investors have them. However, retirement accounts such as IRAs are legally unable to trade on margin, so margin accounts are off-limits there. A margin account will only cost money if you borrow, and the rate varies by brokerage. Some offer competitive rates or a floating interest rate, while others offer a relatively fixed margin rate. The table below gives you the details on rates for some of the major brokerages.
|3.69% (floating rate 1.5% above benchmark rate)
As you can see, running a substantial margin loan is not always cheap, though it’s usually better than a credit card. Most major brokerages are charging 9%-10% annual interest.
Is a margin account right for you?
Margin accounts can be great if you use them prudently, that is, not overusing them. Just like using a credit card can be smart if you pay off the bill and keep the outstanding balance low, using margin can be an effective tool that allows you to buy stock opportunistically and then fund that purchase at a later date.