When you find your dream house, you scrape together a down payment and secure a mortgage loan to cover the rest. When you discover a great deal on a surround sound system and are short on cash, you can pull out your credit card. When you identify a great stock in which you want to invest and decide to buy more shares than you can currently afford, you can get a broker margin loan.
Here’s what you need to know about broker margin loans. They can make you a bundle or cause you to lose the shirt off your back. The trick to leveraging gains is using margin loans wisely and being prepared if the stock you bought starts to tank.
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What is a Broker Margin Loan?
A margin loan is an interest-bearing loan through which you gain access to funds by borrowing against securities you already own. These types of marginable securities are typically stable stocks or bonds. If a broker lets you borrow against your marginable assets, as M1 does, we call it a broker margin loan.
Think of it as a type of equity loan. A mortgage lender can lend you cash against the equity in your home. A brokerage firm can lend you funds against the equity in your portfolio.
Individual brokerage firms can define which stocks, bonds, and mutual funds they consider marginable. The list must follow specific guidelines and typically includes securities that (a) sell for at least $5 per share and (b) are currently traded on the major U.S. stock exchange.
Your brokerage may choose to exclude specific high-risk securities. Retirement accounts or custodial accounts are also ineligible. Ask your broker which assets in your portfolio are marginable they can advise you about your current “buying power.”
The value of your marginable securities serves as collateral for your margin loan. Since stocks may go up or down daily, the buying power of your portfolio will also fluctuate. A high-value portfolio full of marginable assets can stand as collateral for a substantial margin loan.
A broker might let you borrow up to 50% or even 75% of the purchase price of the stocks you want to buy. You could also make a single buy and then use those stocks as collateral for a second buy. If you don't repay the loan, the broker can then seize assets from your brokerage account.
Why Take a Broker Margin Loan?
If you have identified a stock you believe will rise quickly in value, but are short on cash, a margin loan can help. For example, if you have $10,000 in your brokerage account, you can use it to pay for part of a stock purchase.
Individual brokerages control margin loan parameters. However, it's not uncommon to see brokers willing to give you up to 50-70% of your proposed stock purchase value. Your best course of action is taking less than the brokerage offers to give yourself some buffer.
Suppose the stock you are buying is $100 a share, and you want to buy 200 shares. You purchase 100 shares with the $10,000 from your account and another 100 shares with a broker margin loan.
If your broker is willing to cover up to 70%, you may have some wiggle room if your share prices drop. The shares of stock you just purchased may secure your margin loan or other marginable assets in your brokerage account can secure the loan. Think of it as a portfolio line of credit, such as the one offered through Wealthfront.
You now have $0 in your brokerage account, a debt of $10,000, and 200 shares of stock worth $20,000. If the stock share price goes up to $160 a share, you can sell your shares for a total of $32,000.
If your theoretical margin loan interest is 6% and you hold the loan for one year before selling the stock, you'll pay back your loan of $10,000 plus another $600 in interest. This payment leaves you with $21,400. If you subtract the $10,000 you had in your brokerage account to start with, your profit becomes $11,400.
Compare this with the result had you only invested the $10,000 in your brokerage account. After buying 100 shares and holding them until the share price reached $160, you would have made a $6,000 profit. In this situation, you can almost double your gains using the broker margin loan method.
Margin Loan Interest
Margin loans typically do not have an amortization schedule. You don't have to make preset payments. The monthly interest charges will accrue, and you can pay the principal on your own schedule (assuming your stock holds its value.)
If you use a margin loan to purchase taxable investments, consult with your tax professional. Under certain circumstances, itemized deductions can include tax-deductible margin interest.
You can pay less in interest for your broker margin loan if you pay down the principal monthly instead of waiting until you sell your stock shares. If you treat the theoretical margin loan like a one-year loan, you could make monthly payments of around $860.
In that case, you could entirely pay off your loan in one year. The total interest you paid would drop to around $328. Since margin loan interest rates are usually quite low, this may not be a primary concern.
The real advantage of paying off your loan as quickly as possible has nothing to do with interest. Paying down the loan principal can keep you from being subjected to a margin call.
What Is a Margin Call?
If the share price of the stock you purchased drops, the percentage split on your margin loan changes. The broker advanced you $10,000 to make the buy, which at the time was 50% of the total worth of the shares.
However, remember that the broker is willing to carry as much as 70% of the share value. Since $10,000 is 70% of $14,286, you'll be fine as long as the value of your assets stays at or above that amount.
If the share price drops to $85, your 200 shares now have a value of $17,000. That keeps the $10,000 margin loan still well below 70%. However, if the downward trend seems likely to continue, this could be a sign that you should diversify.
If the share price drops to $70, you're in trouble. Your 200 shares are now worth only $14,000. The brokerage is within its rights to issue a margin call.
Margin calls are a crucial part of what you need to know about broker margin loans. A margin call is a demand for you to add either cash or more marginable assets to your account to make up the difference between the current value of your shares and the percentage limit of your margin loan.
In this scenario, you have a $246 shortfall. If you won't or can't add cash or assets, the brokerage can sell your assets. They may sell only a portion, enough to bring the account back into balance. Alternatively, they may choose to close the position.
If they choose to close out the position, they’ll sell all 200 shares for $14,000 and repay the margin loan, including interest. You’ll be left with less than $4,000a more than a $6,000 loss, considering you started with $10,000 in your brokerage account.
Essential Facts About Margin Calls
You cannot become complacent about your portfolio and assets. Your brokerage firm can do any of the following without providing you advance notice:
- Refuse to give you a time extension to meet a margin call (especially if stock is in freefall)
- Increase their maintenance margin requirements at any time
- Remove securities from the marginable list at their discretion
- Sell any securities in your account to meet the margin call (without your approval or consent)
Buying high-risk stocks on the margin can amplify your risk. Never ignore a margin call the brokerage will likely close the position, and you’ll suffer extreme losses.
How to Avoid a Margin Call
There are several ways to reduce the risk of a margin call.
You can opt to borrow less if the margin loan allows up to 70%, only borrow 50% of your total stock purchase price. If the maximum is 50%, you can borrow 30%. This method gives you room to weather ups and downs in the market without having to top off your brokerage account or worry about a margin call.
You can also pay down the margin loan as quickly as possible. Once you repay the loan, the brokerage has no more direct interest in your portfolio's performance. You can safely wait out dips in the market and not worry about whether the brokerage might decide to close the position.
Another way to protect yourself is to set up your own "trigger point" for reviewing your investments. For example, if a stock price of $70 triggers a margin call, set an alert to tell you when the stock dips to $85. This early warning system can give you extra time to come up with a plan.
Finally, segment your portfolio into two lists. Identify securities you want to hang onto if at all possible. The rest can be stocks you are willing to liquidate, if necessary, to protect your position in stock purchased with a margin loan.
Benefits of Broker Margin Loans
The most obvious benefit of a margin loan is the ability to magnify profits. You can easily double your profits with a margin loan on a rapidly gaining stock.
Another benefit of margin loans is the meager interest rate. The interest rate for margin loans is often lower than that for a credit card, personal loan, or home equity loan.
If you have a substantial portfolio, you can take the cash from a margin loan and make non-investment purchases. You'll need to keep an eye on your securities to make sure you don't lose them to a margin call.
Risks of Broker Margin Loans
The risk of taking a margin loan is that while you can magnify gains, you're also magnifying potential losses. You could lose your entire investment and even end up owing your brokerage money if the stock drops precipitously.
If stock values dip even slightly below the purchase price and stay there, you might have to hold a position long-term as you wait for a rebound. That can put you in a bad position if you hit a real-world financial snag and need to become liquid.
Here's what you need to know about broker margin loans that your brokerage may not tell you:
If you have a margin loan, all of your securities are considered collateral you don’t get to pick and choose. Your brokerage can use your account as collateral for its own investments.
Securities used for multiple transactions create a "collateral chain." The chain includes all of the people or entities connected to the same securities. This exposure is called rehypothecation.
Ideally, each debtor repays their loan, and no one has reason to seize any collateral. However, if your brokerage or another debtor in the chain defaults on a transaction, your collateral is their collateral.
Just one break in the chain can put your securities at risk. That's why you need to work with a brokerage firm you can trust.
Adding Margin Trading to Your Account
A regular brokerage account isn't automatically a margin trading account. You'll need to open a margin account or add margin trading to your existing account.
To get a margin loan, you also need to meet minimum cash requirements called the minimum margin. The Financial Industry Regulatory Authority (FINRA) requires you to deposit at least $2,000 to open a margin account. Some brokerages set a higher minimum margin.
The reality of margin trading is that it's inherently high-risk. There's always a gamble with any stock you buy, but you can manage the risk with blue-chip stocks and diversify your portfolio.
With margin trading, you leverage your position until you're way out on a ledge. If the price of a stock you buy goes up, your profits multiply. If prices go down, you could be in for a world of financial hurt.
For aggressive traders with deep pockets to cover a potential margin call, the risk may seem well worth taking. For new investors with a limited safety net, margin trading can be a tightrope walk.