Margin loans are a type of loan that an investor takes out from a brokerage to buy investments. An investor typically borrows from a brokerage if they don’t have the cash balance in their trading account to cover the cost of a trade or investment – so, they use credit from their brokerage to cover the costs.
While there are risks associated with using margin and margin loans, they can also increase an investor’s purchasing power and bolster potential returns.
What Is a Margin Loan?
A margin loan is a loan from your brokerage to pay for securities that you can’t cover with cash. Similar to any other loan, you must apply for the account and be approved before you can borrow funds; and your brokerage will charge interest on any funds you borrow.
Having a margin account by definition enables you to take out a margin loan (the two are synonymous in many ways). Having the flexibility to buy securities on margin gives many traders the ability to take positions they might not have been able to afford otherwise. In fact, margin loans are a cornerstone to putting together effective day trading strategies, for advanced investors.
💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.
Understanding Margin Loans
Understanding margin trading can be tricky, but for the average investor, all you really need to know is that a margin loan is essentially a short-term financing solution. If you want to buy securities, but don’t have the cash in your account, your brokerage may allow you to buy those securities using credit. It’s similar to a line of credit, in that way.
So, that’s what margin debt is: The result of a margin loan, in which a trader borrows money to buy securities.
How Margin Loans Work
While we’ve mostly been discussing margin loans in terms of trading and investing, they could be used for any purpose. But almost always, a margin loan is used to buy securities.
As for the process of how they actually work: A margin loan is more or less like any other loan. To get one, you’ll need to apply and qualify for margin on your brokerage account (typically called a “margin account”).
Margin Accounts and How They Work
Like other forms of lending, margin loans have strict criteria. In addition, these accounts are governed by industry regulations as well as the policies of individual institutions, so be sure to understand how your desired margin account works. Each brokerage has different rules and eligibility requirements, and FINRA, for example, also requires you to deposit a minimum of $2,000 or 100% of the security’s purchase price, whichever is less. This is the “minimum margin.” Some firms may require you to deposit more than $2,000.
If you’re approved for a margin account, you’re able to trade using a margin loan — up to a certain amount. According to Regulation T of the Federal Reserve Board, you may borrow up to 50% of the purchase price of securities that can be purchased on margin.
This is known as the “initial margin.” Some firms require you to deposit more than 50 percent of the purchase price. (Also be aware that not all securities can be purchased on margin. Only those deemed “marginable” can be traded on margin.)
If you have $5,000 in your brokerage account, and you want to buy Stock X, which is valued at $50 per share, with a 50% margin you could buy 50% more than your cash balance: 200 shares instead of 100. But half of those (100 shares) would’ve been purchased on margin — so, you’d need to settle up your account at some point, if or when you decide to sell your shares (hopefully for a profit).
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How Margin Interest Works
The other important thing to remember about margin loans is that they are, like pretty much all loans, subject to interest charges. Your brokerage is going to charge you for the money you borrow.
Margin interest is a big topic unto itself, but the key takeaway is to know that you’ll be on the hook for paying your brokerage back for the money you borrow, plus interest charges.
You’re probably thinking: “Can I avoid paying margin interest?” The answer is that it depends on how fast you can pay your margin balance back. Most brokerages will charge interest by the day and add the charges to your account monthly. So, if you have cash or can sell securities and pay your balance off before interest accrues, it’s possible.
💡 Quick Tip: How do you decide if a certain trading platform or app is right for you? Ideally, the investment platform you choose offers the features that you need for your investment goals or strategy, e.g., an easy-to-use interface, data analysis, educational tools.
Margin Loan Pros and Cons
Marginal loans can be highly useful for traders and investors. But like almost any financial instrument, margin loans have their pros and cons.
The biggest upside of margin is that it can open up a new swath of investing choices for traders. That means increasing their buying power, and allowing them to buy securities that may have otherwise been too expensive. This can increase potential profitability, too.
Conversely, traders who aren’t careful can’t quickly find themselves in debt if one of their trades backfires.
There are also interest charges to consider, as discussed. And if things really go sideways, some traders may experience a “margin call,” which is when your brokerage sells your assets without warning to settle up or get your account balance back within its requirements.
Here’s a quick rundown:
Margin Loans: Pros & Cons
| Pros | Cons |
|---|---|
| Increased trading capacity | Traders can accumulate debt |
| Traders can buy pricier securities | Interest charges |
| Increased potential gains | Potential margin calls |
Typical Margin Loan Rates
Margin loan rates, or, the interest rate charged by a brokerage for using margin, vary. Brokerages make the information available to traders and investors, so finding what types of margin loan rates you’re subjected to usually just requires a little research (or a call to your broker).
As mentioned, a brokerage will probably charge different interest rates depending on your overall margin balance, and how much you’ve borrowed. Lower balances are typically charged higher interest rates.
Here are some hypothetical examples: Let’s say Brokerage ABC’s margin interest rates vary between 4% and 8%, depending on the trader’s balance. Traders using up to $24,999 in margin will be subject to the highest interest rate (8%), whereas traders with more than $1 million in margin debit are subject to the 4% rate.
Brokerage B, however, has a different scale, with traders in margin debt up to $24,999 subject to 8.5% interest, and those with balances between $500,000 and $999,999 subject to 6.5%.
So, while brokerages do vary in what they charge for margin loan rates, they tend to be similar. To know your exact rate, contact your brokerage, or look up the current rate schedule on the company’s website.
The Takeaway
Margin loans are similar to any other type of loan, but are typically used for the purpose of buying stocks or other securities. Once you’ve applied for and been approved for a margin account, which is akin to adding a line of credit to your existing brokerage account, you’ll have the flexibility to buy more investments than if you were relying only on cash.
That said, you’re on the hook for repaying the money you’ve borrowed, with interest. If you’ve made a profitable investment, this shouldn’t be a problem. But if you invest in Stock X on margin, say, and the price drops, you would still owe the full amount you’d borrowed to buy the stock, plus interest.
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FAQ
Can you withdraw a margin loan?
Yes, it’s possible to withdraw a margin loan, although the specifics will depend on an individual brokerage, as will any applicable interest charges.
Are margin loans a good idea?
Margin loans can be useful for many investors and traders, and whether or not they’re a good idea will depend on the specific individual considering taking one out. They do have risks, but upsides, too.
How do I pay back my margin loan?
The simplest ways to pay back margin loans are to either deposit cash into your brokerage account to get the balance back to zero, or to sell holdings that will result in a positive or neutral balance.
How much collateral is required for a margin loan?
The collateral required to take out a margin loan depends on a specific brokerage, but it’s not uncommon for brokerages to require somewhere between 30%, 40%, or 50%.
What happens if you can’t pay back a margin loan?
If you can’t pay back a margin loan, the brokerage will likely reach out to see what can be done, or lock you out of your account. Further, it could end up liquidating securities in your portfolio in order to cover the debt.
Photo credit: iStock/Sergey Nazarov
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