- A margin loan is a type of interest-bearing loan that allows you to borrow against the value of the securities you already own in a margin account.
- Margin loans increase your purchasing power since you can buy more securities than you could with cash.
- While taking out a margin loan can increase your earning potential, it can also magnify your losses.
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When opening a brokerage account, you have two options: the cash account and the margin account. If you decide to open a margin account, the amount you deposit in your account will serve as collateral for the margin loan.
Here’s what you need to know about what a margin loan is, how it works, and the pros and cons of using it.
What is a margin loan?
A margin loan allows you to borrow against the value of the securities you hold in your brokerage account. Whether you have stocks or bonds in your portfolio, these investments serve as collateral to secure the loan.
Each brokerage firm has its own conditions on margin loans and on securities it considers eligible for margin. Typically, they will have a list of stocks, mutual funds, and bonds that are eligible for margin. You can use the margin to leverage your account as it will increase your purchasing power.
How do margin loans work?
Margin buying occurs when you buy stocks, bonds, mutual funds, or any other market security by borrowing money from a broker. âIf you buy on margin, you will be borrowing money from a brokerage firm to buy stocks,â says Baruch Silverman, founder of The smart investor. “Put simply, you could think of it as a loan from a broker.” When you buy investments on margin, you are essentially using your securities as collateral to secure a loan.
Most brokerage firms allow clients to borrow up to 50% of the value of securities eligible for margin. So if you have $ 4,000 of marginable investments in your margin account, you can borrow up to $ 2,000. Using a margin increases your purchasing power because you can buy more securities than you could otherwise buy with a cash account.
As with any other loan, âmargin loans bear interest,â says Cliff Auerswald, chairman of All reverse mortgages. The annual percentage rate of interest on margin is generally lower than that of personal loans and credit cards. In addition, “there is no repayment schedule for everyone,” he adds. Margin loans do not require a fixed payment schedule and interest charged is applied monthly.
Advantages and disadvantages of margin loans
There are several potential benefits of using margin, including:
- Increase in purchasing power. A margin loan allows you to buy more investments than you could otherwise buy with a cash account. Let’s say you want to buy 100 shares of a particular company, but you have less money in your brokerage account. When you use margin, you are leveraging your account to buy more investments.
- Easy access to funds. With a margin account, you can access cash without having to sell your investments. Your brokerage firm can give you instant access to funds, which you can pay back at your convenience by depositing money or selling securities.
- Allows you to diversify your portfolio. A margin loan gives you more purchasing power, which means you can buy more different securities like stocks, bonds, mutual funds, and exchange traded funds. A diversified portfolio translates into a low risk investment.
- You can repay the loan by depositing cash or selling securities. Buying on margin allows you to pay off the loan by adding more money to your account or by selling some of your investments with margin.
- There is no fixed deadline for repayment of the loan. The advantage of a margin loan is that you can pay off the principal at your convenience, as long as you meet your maintenance margin requirement.
As with any other financial tool, margin loans also have their drawbacks.
- You may face a margin call or a liquidation of securities. Margin accounts have a minimum maintenance requirement, and if they are not maintained, you may be subject to a margin call. A margin call is an alert from your broker to load more money into your account, sell investments, or add more assets that may be subject to margin. If you don’t answer a margin call, your broker can take quick action to liquidate the securities in your account.
- Interest rates can go up. Margin loans bear interest but tend to be lower than other forms of lending. But, if you don’t pay the interest on your margin loan for a long time, interest rates can go up, which can cause your loan cost to increase.
- You may suffer losses if the securities in your account lose value. While a margin loan can increase your potential returns, the opposite is true it can also magnify your losses. When the securities in your portfolio fall in value, your losses increase. It is even possible to lose more than your initial investment.
The financial report
A margin loan allows you to borrow against the securities you own in your brokerage account. Buying on margin increases your purchasing power since you can buy more investments than you could otherwise buy with cash. While margin can increase your potential returns, it can also magnify your losses. Plus, even if you’re right with your trades, interest charges can eat into your profits.
Generally speaking, buying on margin is very risky and you can lose more than your initial investment, especially if you are inexperienced. If you do decide to take out a margin loan, be sure to weigh the benefits and the risks.