By Peter Mastrantuono
Many Americans are familiar with borrowing money to buy an asset. The most common example is taking out a mortgage to fund the purchase of a home.
Investors can pursue a similar strategy with buying stocks by borrowing money from a brokerage firm, using the value of stocks or other securities as collateral. Known as a margin loan, buying stocks on margin can enhance investor profits when prices rise, but can magnify losses when the stock price falls.
How Margin Loans Work
To utilize margin, individuals need to sign a margin agreement with the broker with which they have their brokerage account. Margin loans are subject to an array of rules from a variety of regulatory bodies, including the Federal Reserve Board, the Financial Industry Regulatory Authority (FINRA), and the relevant securities exchange (e.g., New York Stock Exchange). Brokerage firms may in addition establish their own policies that may make margin requirements more stringent than those required by the regulators.
For new purchases of a stock, the initial margin requirement is 50%. So, for example, if you wish to purchase $10,000 of XYZ stock on margin, an investor would need to deposit $5,000 in cash or have at least $5,000 in marginable securities (e.g., stocks, bonds, mutual funds) in his or her brokerage account.
After the initial purchase, an investor must maintain a minimum of 25% of equity in the account at all times, or, in this example, at least $2,500 of equity. If XYZ’s stock price declines to a point where the equity in the account drops below that level, the investor will be required to add the requisite cash (or marketable securities) or sell other account positions to bring the equity level back to its minimum maintenance level.
As noted, brokerage firms may adopt their own margin requirements, which means that a firm may require a 30% equity maintenance and reserve the right to raise its equity maintenance requirement at any time and to any level. An increase in the equity maintenance requirement is often in response to increases in market volatility.
Brokerage firms charge interest on margin loans. Interest rates among major brokerage firms will vary widely, so it may pay to comparison shop.
The Benefits and Drawbacks of Margin Loans
Borrowing to buy a stock can magnify an investor’s profits by providing them with the ability to buy shares with a lower cash outlay. This, of course, cuts the other way. When the price of a stock bought on margin is falling, losses are amplified. Should losses lead to a margin call—the demand for additional collateral—a brokerage firm may sell any securities in an account without even contacting the account owner.
In a worst-case scenario, an investor buying on margin may lose more money than what was originally invested. Because margin trading involves substantially higher risks, only experienced investors with a high tolerance for risk should consider trading on margin.
For investors interested in using margin to boost profit potential, they may want to discuss with their financial advisor the general margin requirements of the brokerage firm where they have their account and lean on the advisor’s expertise to execute a margin trading strategy in a responsible way.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.