Cash-strapped investors with significant assets have two ways to generate money for spending or new investment: sell some of what they own, or borrow against it using a margin account.
Selling is simpler and less risky, but means unloading assets that might grow in value. A margin loan can be an inexpensive way to borrow, since it is secured by assets in the account. But the borrower could face the dreaded “margin call” if that collateral loses value. Many small investors think that’s just too risky, but are they being overly cautious?
Probably not, says Robert Johnson, president of the American College of Financial Services in Bryn Mawr, Pennsylvania.
“My advice to people considering margin is to heed Berkshire Hathaway (NYSE: BRK.A, BRK.B) Vice Chairman Charlie Munger’s words: ‘Three things ruin people: drugs, liquor and leverage,'” Johnson says.
[See: 7 Investment Fees You Might Not Realize You’re Paying.]
Still, it’s worth knowing how these loans work, the benefits and ways to minimize risk.
As mentioned, a margin loan uses assets like stocks as collateral. Margin accounts are therefore set up at a brokerage that holds the investor’s accounts, and the applicant must complete a form to show he or she understands how the account works and the risks.
Loan rates are lower than on unsecured loans like credit cards. Rates at Fidelity Investments, for example, currently start at 8.575 percent for debt less than $25,000 and gradually decline to 4.250 percent for debt of $1 million or more.
To reduce risks for both lender and borrower, brokers typically limit loans to half the value of the assets in the account, with securities purchased with the loan added to the collateral. Once approved, the loan is a revolving line of credit that the investor can use as needed. Proceeds from any sales must be used to pay off the debt, and while there usually is no repayment deadline, interest charges are added to the balance and snowball over time. Of course, interest charges reduce gains and increase losses.
The big risk is a margin call. That’s when the collateral loses so much value the lender no longer considers it adequate. Typically, that’s when equity — the value of assets in the account, less the debt — falls to 25 percent of the assets’ value, though the broker may set a higher threshold.
At that point the broker will demand that cash be put into the account to reduce the debt or additional assets be pledged as collateral until the ratio between assets and debt is returned to the required “maintenance” level. If the account holder does not respond very quickly, the broker starts selling assets in the account to restore the ratio. Since the problem was caused by a drop in asset values, this can mean selling at a very inconvenient time, perhaps at a loss, and probably missing any rebound.
[See: 8 Ways to Satisfy a Craving for Restaurant Stocks.]
The calculations can be quite tricky, because any assets purchased with the margin loan are added to the collateral and asset values constantly change. In a market freefall, the investor can be taken unawares and have assets sold before he or she can respond.
Investors can also use margin accounts to borrow cash that is not used to purchase securities. Since cash is removed from the account and does not provide additional collateral through investment, the borrowing limit is lower than if the loan is used for investing.
In other words, a margin account can blow up in your face if you’re not watching it carefully. It’s especially dangerous if the collateral includes volatile stocks that could plunge unexpectedly, or during a market meltdown.
“I always recommend against a margin account for ordinary investors,” says Even Tarver, investments analyst at FitSmallBusiness.com, a New York City-based site for small businesses. “A margin account can lead to financial distress and isn’t something that people should open lightly.”
But they are appropriate for savvy investors capable of taking the risk, he says, adding that borrowing on margin can supercharge returns if things turn out right.
Margin loans are useful for speculators trading options who don’t want to put up cash for options premiums, Tarver says. Losses on options bets are limited to the premium, which is just a fraction of the underlying stock’s market price. That means a sour options bet is less likely to trigger a margin call.
But options trading is not for everyone, either.
Margin users can limit risk by borrowing less than the maximum allowed, so they won’t be hit with a margin call even if their securities drop substantially.
And it can pay to have cash or securities in reserve outside the account, to be pumped in to meet a margin call.
“For basic investors looking to save for retirement, I would suggest sticking to blue chip stocks that you can afford with money already in your bank account,” Tarver says.
[See: The Top 10 Investment Portfolio for Millennials.]
“Ordinary investors should not utilize leverage in investing,” Johnson says. “If one wants to be more aggressive in investing, have a more aggressive asset allocation. Leverage is wonderful in a bull market and is devastating in a bear market. And we all know that no one rings a bell at market tops and bottoms.”
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Margin Investing Is Risky originally appeared on usnews.com
