Sophisticated investors can use a margin loan to increase their personal wealth.
A margin loan or margin account is a loan made by a brokerage firm to a customer that allows the customer to buy stock on credit. The term margin itself refers to the difference between the market value of the acquired shares and the value borrowed from the brokerage firm. Interest on the margin loan is normally calculated on the outstanding balance daily and debited to the margin account. Over time, debt rises and interest accumulates. In addition, the brokerage holds the bonds as collateral for the loan.
A simple example of buying on margin might be an investor buying stocks with a market value of $10,000 but using only $5,000 of his own money. The other $5,000 would be provided by the brokerage as a margin loan.
Sounds simple, but margin lending isn’t simple.
If you want to trade on margin, the first thing you need to do is open a margin account. By law, this requires an initial investment of at least $2,000. But this amount may be higher, depending on the broker’s own rules for opening an account. This configured value is known as the “minimum margin”. Once your account is opened, you can borrow up to 50% of the price of any stock you want to buy. Understand, you don’t have to borrow all 50%; the loan amount can be less than 50%. The “initial payment” of 50% is called the initial margin. As long as stock prices stay steady or go up and you pay the interest, your life will be fine.
However, you need to be aware of what is called the “maintenance margin” in case stock prices fall. According to the rules of the New York Stock Exchange (NYSE), anyone who buys shares on margin must keep at least 25% of the total market value of the securities that are in the margin account. Some brokers demand an even higher percentage.
Dropping stock prices can bring your account below the minimum threshold and the broker will require you to put in more cash or bonds to reduce your holding to a minimum. The broker’s call demanding these incremental funds is known as a “margin call”. Depending on the terms of the margin loan agreement you originally signed with the broker, they may even have the legal right to sell securities from your account without consulting you, to get back to minimum maintenance.
Without a doubt, margin accounts allow an investor to gain control of a large block of stocks with minimal investment. Sophisticated investors will use a margin loan to increase their personal wealth using the “leverage” provided by the borrowed money.
However, if stock prices go the wrong way, the investor with the margin loan is not only responsible for borrowing money, but also keeping the minimum of his margin account. Now, leverage is working in the opposite direction and falling stock prices combined with outstanding loan margin can cause significant financial hardship for the investor.