What does it mean to borrow on margin? A margin loan is a type of loan that some brokerage firms will offer that allows investors to borrow money using the securities they already hold in their brokerage account as collateral for the loan. Margin loans enable investors to markedly increase their buying power. A margin loan may sound risky, but for the right investors, it can provide liquidity at a lower cost than traditional loans.
Margin loans are not ideal for everyone. If you are contemplating borrowing on margin, consult with your fee-only financial planner to discuss the potential tax implications of margin loans.
How does a margin loan work?
Homeowners frequently borrow money from banks, using the equity in their homes as collateral. In the same way, a brokerage firm may lend you money using the value of certain bonds, stocks, and mutual funds you have in your portfolio as collateral. You can use the loan for any purpose, including buying more securities. However, your mortgage provider may not allow you to use borrowed funds as a down payment for real estate.
How much can you take as a margin loan?
It varies by brokerage firm, but most brokerage customers can borrow up to 50% of the purchase price of new investments as a margin loan. This can double your purchasing power. Theoretically, you could pay cash for 50% of your investment, and your investment firm would lend you the other 50%. Of course, the more you borrow, the higher the risks and taxes.
Since you are using the value of your marginable securities as collateral for your loan, as their value fluctuates, so does the amount you can borrow.
What are the risks and costs associated with margin loans?
Like all loans, you will need to pay interest on the amount you borrow. The amount varies by brokerage firm but is usually calculated daily and posted to the account monthly. Margin interest rates are typically lower than those for credit cards and personal unsecured loans. Be prepared. The interest rate will fluctuate during the term of your loan.
Because of your increased buying power, margin can substantially increase your profits when stocks are rising in value. Investors who closely follow the market can buy more securities using leverage than they could with cash alone.
However, market conditions can change quickly. If your stock purchase decreases in value, you still need to pay back your margin loan and interest. So, unfortunately, borrowing on margin can also increase losses when you buy more securities in a declining market.
Brokerage firms typically require investors to maintain a certain percentage of equity in the account they use as collateral against purchased securities to reduce their risk. If the value of your equity decreases during a market downturn and it falls below 30% to 35%, your brokerage firm may issue a margin call (or maintenance call). When this occurs, you must deposit more cash or marginable securities in your account to bring the equity back up to the required level.
If prices drop quickly, brokerage companies may sell your securities or other assets in your account, even at a loss, without notifying you. You may not be able to choose which securities to sell to meet a margin call.
What securities and accounts qualify as margin collateral?
Most government agency bonds, most mutual funds held for 30 days, and most stocks traded on a major U.S. exchange with a share price of $3.00 or higher per share are eligible.
Among others, you cannot use individual retirement accounts (IRAs), 401(k) accounts, 403(b) accounts, certificates of deposit, conservatorships, guardianships, and charitable accounts as collateral for margin loans.
Margin can allow investors to borrow against their own securities for a short-term loan without needing to complete a loan application. When using margin prudently, investors can retain the securities in their portfolio, even during a period of low cash flow.
While margin loans provide greater investment flexibility and portfolio diversification, they do come with risks. To reduce your risk, it is a good idea to use a diversified portfolio and closely watch its performance. Borrow less than the maximum amount you are entitled to use. This can reduce your risk of a margin call and forced sale of your securities.
There is no one-size-fits-all guide to investment. Working with a wealth manager who uses a fee-only financial planning structure can ensure you make the best financial decisions for yourself and your loved ones. Ready to secure your financial future? Call us today at 866-395-1786 to get started.
