Risks and Rewards of Borrowing on Margin


Almost everyone needs a lump of cash sometime, whether to buy a car, pay college tuition, make a down payment on a house or pay off a pile of bills or credit card debt. But many investors overlook one of the best and least-expensive sources: borrowing on “margin” and using stocks, bonds or mutual funds as collateral.

With stocks producing fat returns during the past few months, and with risks appearing to diminish as the recession winds down, margin accounts look appealing. Many charge rates of 7% to 8.5% for loans of less than $100,000, and even less for bigger amounts. It’s a lot better than you can do with a credit card. (Use the shopping tool to see card rates.)

For most investors, interest paid on margin loans is tax deductible. And by borrowing against your investments instead of selling them to raise cash, you can benefit if the market keeps going up. Unlike a home equity loan, there are no closing costs or application fees on a margin account.

Margin accounts can present serious risks, but those can be kept under control by keeping loans small relative to the assets you use as collateral.

Margin accounts are set up through your broker, and you’ll have to fill out a questionnaire to show you can handle the risks and understand them. These are revolving-credit accounts, allowing you to borrow any amount up to your limit and pay it back on your own schedule.

In fact, you generally don’t have to make any payments, as interest can be added to your loan amount.  That’s not something to do routinely, as the interest on interest will snowball, but it’s a nice option if you have a bad month. Interest rates float according to market conditions.

There are two loan limits. The first is for loans used to buy more securities in the same account. Generally, the loan amount is limited to half the price paid. The math gets tricky, because securities bought on margin are added to collateral in the account. So brokerages like Charles Schwab (Stock Quote: SCHW) Merrill Lynch (Stock Quote: BAC) and others keep a constant online tally of your loan limits. Typically, you can borrow enough to double the size of your account.

The second limit applies to cash loans that are not used to buy more marginable securities, and therefore will not add new collateral to the account. This limit is lower, typically less than half what you could borrow to buy securities. Once the loan is made, you are subject to a “maintenance margin” that limits the size of your loan relative to the value of the securities in the account. Many firms have a 30% or 40% requirement.

The Securities and Exchange Commission has a good example of how this works. If you started with $8,000 in cash and securities in your account, you might borrow $8,000 to buy securities, increasing the value of your holdings to $16,000. If the value of the securities dropped to $12,000, your “equity,” the value of assets minus the $8,000 loan, would be $4,000. If the firm had a 40% margin requirement, your equity could not fall below $4,800, which is 40% of $12,000.

When equity falls below the minimum, the broker issues a “margin call” requiring that you add cash or securities to raise your equity. If you don’t do this immediately, the broker will sell some of your holdings to pay down the debt. Obviously, this is an unwelcome move, as no one wants to sell when prices are depressed. But you can avoid this problem by keeping the loan amount small. If you borrowed just $25,000 on an account worth $100,000, you wouldn’t face a margin call even if the account lost half its value.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

Show Comments

Back to Top