Margin accounts at brokerage firms allow investors to use their stock investments as collateral to take out a loan.
In bull markets, margin loans are more prevalent since stock values are rising. However, when stock values fall, those loans may need to be paid down because of the drop in the value of the stocks used as collateral.
Stories of investors getting burned by margin loans have given margin accounts a bad reputation. But financial experts say there are ways investors can benefit from the flexibility margin accounts offer, as long as people use them with care.
Here are four things to know about margin investing:
— How margin accounts work.
— Margin accounts versus cash accounts.
— How investors go awry using margin accounts.
— Other ways to use margin accounts.
How Margin Accounts Work
Many brokerage firms offer margin accounts when a trading account is opened because it offers some flexibility, says Jeff Chiappetta, vice president of trading services at Charles Schwab (ticker: SCHW).
The Federal Reserve established margin accounts rules under Regulation T which cover how broker-dealers can extend credit. Every brokerage firm is required to monitor their margin accounts, he says.
Marginable securities include stocks, bonds, exchange-traded funds and mutual funds, but there are nuances, Chiappetta says. For example, a low-priced stock or a stock that doesn’t trade on a recognized stock exchange might not be available for margin use.
Regulation T says investors can borrow up to 50% of the purchase price of eligible securities, but brokerage firms may have stricter regulations about how much can be borrowed against a certain security, he says. For instance, brokerages may limit how much an investor can borrow against volatile stocks to reduce risks.
Brokerages may also change margin requirements on accounts or individual securities if the firm feels uncomfortable with the risks of the securities. When that happens, Chiappetta says, the firm may issue a margin call, which means the investor must deposit money or sell securities to cover the shortfall.
Margin Accounts vs. Cash Accounts
Margin accounts are distinct from cash accounts, which don’t let you borrow money to purchase additional investments
In a cash account, you must have cash available to pay for a trade in full by the settlement date — usually one to three days after the transaction. You also can’t withdraw any money from a sale until the settlement date. This can reduce your purchasing power by limiting the amount you can buy to how much money you have on hand, but it also reduces your risk if the market moves against your position.
Your broker also cannot lend out the securities you hold in a cash account without your permission. In a margin account, your broker may lend your shares to short sellers or hedge funds without notifying you. The broker does this to earn additional interest on the lended shares.
How Investors Go Awry Using Margin Accounts
Investors who use margin loans to buy additional securities hope to magnify their gains with leverage, but losses are also increased, says Timothy Hooker, co-founder and accredited investment fiduciary at Dynamic Wealth Solutions. Loading up on margin loans can get investors in trouble.
“If you’re an experienced trader and know what you’re doing, there’s nothing wrong with using margin,” he says. “But if you’re really trying to take your account to the moon and back, then that’s where you can blow up your account and really derail your financial plan.”
John Person, founder of Persons Planet, a trading education and advisory service company, says a good rule of thumb is not to borrow more than 25% against eligible assets, and he recommends keeping the debt-to-equity ratio in an investment portfolio closer to 15% to 20%.
“A small amount of your portfolio can be used to extract cash for small loans,” Person says. “Borrowing more than 25% of your total portfolio is ludicrous because the market can go down.”
A margin call can happen when account values fall under 50% equity, so keeping margin levels low allows investors to control their leverage.
But Person says when investors see their portfolio equity fall in a down market and their debt levels increase because of margin loans, it can be hard to stomach.
“Even if they don’t get a margin call, psychologically it is a big impact that affects people,” he says. “They see their assets devalue, then they panic and they tend to liquidate.”
Other Ways to Use Margin Accounts
Clients who use margin loans are usually tapping them for short-term liquidity purposes, rather than buying risk assets on loan, says Jared Snider, a senior wealth advisor and partner at Exencial Wealth Advisors.
“Most of my clients use a margin account as an interest-only loan, often for bridge purposes,” he says.
Real estate deals where someone is buying a property but is also waiting for a property to close might tap a margin account to be able to bring cash to close the deal on the target property.
“A margin loan is a great way to do that,” Snider says, as it may be preferable to selling highly appreciated securities and taking the tax hit.
Margin loans have no payoff schedule and access to cash is immediate since all the paperwork was filled out when the investor opened their brokerage account, Snider says, which is a benefit versus applying for a bank loan. Interest accrues during that time, although that interest can be tax-deductible for people who itemize.
These loans have higher interest rates than bank loans and are based on tiered rates.
“You may pay higher rates because of the flexibility component,” Chiappetta says, adding that the rates are variable.
Typically, brokerages will change rates when the Fed makes changes to monetary policy.
Person and Snider both recommend investors pay back margin loans quickly because of those higher rates. To do so, investors can add cash or sell securities.
Even though buying stocks on leverage adds risk, Person says it can be a good short-term investing tool for people who use it carefully.
Sometimes experienced traders use margin to bet on a stock with strong momentum and then take profit when price movements slow.
Some traders use it to buy index ETFs that pay dividends to amplify the income return. But to do so, a trader needs to keep a sharp eye on the market, Person says.
“You need to make sure that whatever market you’re in doesn’t stagnate because if you’re stagnating, you’re not receiving a net return,” he says. “Instead, you have a loss from the interest that you’re paying on the money that you borrowed.”
Chiappetta says people who use margin accounts need to stay on top of their portfolio. “A big risk is that clients don’t stay engaged and they lose track of where their equity-to-debt ratio is, and then they’re surprised when the market doesn’t go the way they were expecting,” he says.
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Update 05/17/21: This story was published at an earlier date and has been updated with new information.