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A margin account is a type of brokerage account that lets you borrow money to purchase securities. Buying on margin lets experienced traders make larger investments with less of their own money. Using a margin account as part of your investing strategy, however, means taking on debt, additional costs and much more risk.
Margin loans charge interest, and declines in the market value of securities bought with a margin account could require you to repay the loans at very short notice. Higher risks make margin accounts and buying on margin strategies for experienced investors only. Hereâ€™s what you need to learn to get started with a margin account.
What Is Buying on Margin?
Buying on margin is when you invest using someone elseâ€™s money. When you buy on margin, you are borrowing money to buy securitiesâ€”in finance, this strategy is also called leveraged investing. With leverage, you contribute a small amount of your own money and you borrow a larger sum in order to buy investments.
Margin loans are a form of secured lending. When you take out a loan to buy on margin, the loan is secured with the investments you purchase, much like you secure a home equity line of credit (HELOC) with the home itself. According to SEC limitations, you can only borrow up to 50% of an investmentâ€™s value, and brokerages may have their own limitations on how much you can borrow to buy on margin.
Buying on margin gives you leverage to make bigger investments than you otherwise could, but it also means youâ€™re taking on much bigger risks. Youâ€™re basically betting that an investment will increase in value. If the securities you buy fall in valueâ€”or donâ€™t appreciate enough to cover the cost of margin loan interestâ€”you could owe your broker more than you earn from the investment.
What Is a Margin Account?
A margin account allows you to borrow money to buy securities on margin. Unlike a cash brokerage account, which only allows you to spend as much money as youâ€™ve deposited, a margin account leverages your purchasing power with debt.
When you open a margin account, your brokerage extends you a line of credit you can use to buy securities. The securities are collateral for the loan, and the brokerage charges you an interest rate. Unlike other forms of debt, margin loans donâ€™t have a set repayment schedule, but you must maintain your account value above a certain threshold.
Margin accounts have a few key regulator requirements set by the Securities and Exchange Commission (SEC), FINRA and other entities. Note that your brokerage may set even higher requirements.
- Minimum margin. Before you can begin trading on margin, you must meet the minimum margin requirement. FINRA requires you deposit in your margin account the lesser of $2,000 in cash or 100% of the purchase price of the stocks you intend to buy on margin.
- Initial margin. When you start buying on margin, you are generally limited to borrowing 50% of the cost of the securities you intend to buy. This can effectively double your purchasing power. If you have $5,000 in your margin account, for example, you would be able to buy $10,000 of a stock on margin.
- Maintenance margin. After youâ€™ve purchased securities on margin, you must maintain a certain balance in your margin account. Called maintenance margin or maintenance requirement, it calls for at least 25% of the assets in your margin account to be owned outright by you. If your account falls below this threshold, due to withdrawals or declines in the value of your investments, you may receive a margin call (more on that below).
Margin accounts are a standard feature available for taxable accounts at most brokerages. Federal guidelines prevent most tax-advantaged retirement accounts, like individual retirement accounts (IRAs), from being available in margin accounts.
Margin Interest Rates
Margin interest is the annual interest rate you owe on a margin loan or a margin account. Interest rates vary from brokerage to brokerage, but some planners consider margin rates a little high.
â€œInterest rates on margin loans quite consistently seem to be 3% or 4% higher than what you would get for a home equity line or some other reasonable type of debt,â€ says Brian Cody, a certified financial planner with Prudent Financial in Cedar Knolls, N.J.
Thatâ€™s not such a big deal if youâ€™re using margin for short-term trades, but interest costs can add up if you use margin extensively. Each month your interest costs will eat into your returns, and investments purchased on margin need to remain in the green to prevent a margin call.
What Is a Margin Call?
A margin call is an alert from your brokerage that the value of your investments has fallen below the brokerageâ€™s threshold of value for your margin loan.
If you receive a margin call, you need to either deposit more money in your account or sell investments to maintain the account value that acts as collateral for your loan. If the value of your investments fall quickly or steeply enough, your brokerage may even sell them without notifying you.
In many cases, a margin call forces investors to sell securities when they are worth less than their initial purchase price. Being forced to sell an investment for less than you paid for it is the core risk of investing with a margin account.
â€œThis makes it a dangerous game to play,â€ says Nate Wenner, a certified financial planner with Wipfli Financial Advisors in Edina, Minn.
The Benefits of a Margin Account
Owning a margin account and buying on margin has benefits as well as risks.
- Leverage lets you make bigger investments. Buying on margin allows you to leverage the value of your investments and buy more. This can potentially increase the size of your returns or allow you to diversify in ways you couldnâ€™t otherwise.
- Margin loans give you access to cash. Margin loans arenâ€™t limited to buying investments. You can also use them to fund purchases outside of your investment account, and once youâ€™ve set up a margin account, it functions a lot like a HELOC.
- Margin accounts let you postpone capital gains taxes. If you need to fund a large purchase, such as a home down payment, but selling investments would force you to realize a large amount of capital gains, you could take a margin loan to postpone the tax bill that would come with a sale. â€œBy taking a margin loan, [you] donâ€™t have any transactions and thereâ€™s no tax recognized,â€ says Wenner. â€œIn most cases, our clients donâ€™t keep this margin loan for months and years on end…They try to pay it back when they have the cash flow, maybe from a bonus at work.”
- A margin account prevents you from needing to sell when the market is down. If you need cash from your brokerage account in a pinch but donâ€™t want to sell your investments at a loss, you can take a margin loan instead. Wenner sometimes advises clients to take out cash from a margin account to cover certain short-term needs, and repay the drawdown when market conditions improve. Note that an emergency fund helps decrease the likelihood you need to take cash from your margin account.
- Margin loan repayment schedules are flexible. Unlike most other loans, margin debt can be repaid whenever you want, as long as you maintain collateral limits in your account. Eventually you must repay the amount you borrow plus interest, but you have plenty of flexibility about when you choose to repay.
- Margin loan interest may be tax deductible. Depending on your situation, the interest on your margin loan may offset taxable income. Talk to your accountant or tax advisor to see how this may apply to you.
The Risks of a Margin Account
Using a margin account has a fair amount of risk because youâ€™re leveraging your investments. These are the main risks you may encounter when you buy on margin:
- Your losses may be amplified. Just as using margin to invest can result in increased returns, it can also multiply your losses if the market goes down. In a cash account, the worst case scenario is that your investment falls to zero. If you have a margin loan and your investments fall to zero, youâ€™ll still owe the balance of the margin loan, plus interest.
- You may encounter a margin call. If the value of the securities in your account falls too far, you may have to sell securities to bring your account back to the margin threshold. Your firm may even sell investments in your portfolio without notifying you, depending on the situation.
â€œAnything you buy can go down in value, so when you buy investments on margin, youâ€™re exposed to more risks because you have liability in terms of the cash youâ€™re borrowing,â€ says Colby Davis, portfolio analyst for RHS Financial in San Francisco. â€œYou have to make sure your investments donâ€™t lose so much value that you lose more than what you owe.â€
How to Manage Margin Account Risk
If you decide to invest with a margin account, you can decrease your risk a few ways:
- Keep a cash cushion. A cash buffer in your margin account can help decrease the chances of facing a margin call. The extra cash buffer gives you extra scope to maintain the required value of your account.
- Donâ€™t pursue highly speculative investments. Margin investing only makes sense if your returns are greater than what youâ€™re paying in interest on the margin loan. Itâ€™s not wise to buy speculative investments in a margin account, as highly speculative bets can rapidly lose value, forcing margin calls.
- Keep an eye on your interest costs. Even though most margin accounts wonâ€™t have a set schedule for loan repayment, you must be aware of the interest costs youâ€™re accruing. Regularly paying down interest charges keeps your balance from creeping higher and eating into your cash cushion.
Do I Need a Margin Account or a Cash Account?
When you open a new brokerage account, the firm will ask you if you want a cash account or a margin account. Novice investors should choose a cash account to begin learning how to trade and invest. Only open a margin account when you understand the risks and have learned how to invest.
Some financial advisors encourage their clients to set up margin accounts so they have access to cash in a pinch. However, this has nothing to do with leveraged investing and more to do with cash flow.
â€œWe generally encourage [margin accounts] with our clients even if we donâ€™t plan to do leveraged investing with them,â€ Davis says. â€œSometimes a client needs money in a hurry, and instead of having to sell securities and wait two days, you can take the money out immediately and sell the securities the next day or the next week. You donâ€™t have to wait as long to get the cash out.â€
Cody views a margin account as the equivalent of having overdraft protection on a checking account. â€œIf you really want to buy an investment and you donâ€™t have the cash instantly available, itâ€™s a quick way to make sure that you have it,â€ he says.
There are generally no additional fees for having a margin account versus a cash account. That said, taking cash on margin is still a bet that your investments will generally grow. If youâ€™re taking a margin loan for more than just a couple of days, and the market falls and doesnâ€™t recover, you risk a margin call.
You Need a Margin Account for Short Selling
Short selling is a speculative trading strategy where you aim to profit from a decline in a stockâ€™s price. When you open a brokerage account, you need to choose a margin account to pursue short selling. Like buying on margin, short selling is a sophisticated strategy thatâ€™s not for novice investors, and the potential losses from a bad trade are much, much higher.
Selling a stock short works like this: You borrow a particular stock from another holder via your brokerage account, you immediately sell the stock and pocket the profit from the sale, and then wait for the value of the stock to fall. If and when the stockâ€™s market value declines, you buy it back and return it to the original owner.
Think of short selling as a kind of mirror of conventional stock investing. Instead of buying a stock in the hopes that its value increases, youâ€™re betting the value of a stock will decrease and youâ€™ll be able to replace the shares you borrow for a much lower price than you sold them for.
The Risks of Short Selling
Short selling involves much more risk than buying a stock long in the hopes the price increases. You ultimately must repurchase the stock that you borrowed and then sold. The more the stock gains in value, the more money you stand to lose.
â€œThe challenge with short selling is that you have unlimited loss potential,â€ Cody says. This is in contrast to normal investing, where losses are capped by the amount you originally paid for a stock. With short selling, there is no maximum to losses. If an investmentâ€™s price drastically increases after you short it, you still must return the number of shares you borrowedâ€”even if the stock price is multiples more than you paid for it.
Consider this scenario: A companyâ€™s stock is trading at $100 but you expect its value to fall, and you execute a short trade. If your instinct is wrong and the company doubles in value, you must buy back shares at twice the price you sold them for.
In addition, federal law requires short sellers to maintain 150% of the value of the stocks they short in a margin account. This helps ensure the investors whose stocks you borrow are protected from the chance of you defaulting on a short trade.
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