Last Updated: February 11, 2024
If you’ve been looking to invest, you may have come across margin stocks without having an idea of what they really meant. In this article, we’ll define what is margin stock, discuss how marginal loans work, and explore the pros and cons of trading margin stocks. We’ll also discuss when to pay back this type of loan to make the most out of it.
What Is Margin Stock?
Margin stocks are any stocks that can be bought and sold on a stock exchange using funds borrowed from a broker. The loan is collateralized by the stocks themselves. This allows investors to buy more shares than they could otherwise afford, amplifying both potential profits and losses.
Here are some of the main characteristics of margin stock:
- Financial Leverage: Margin stocks allow investors to control a larger number of shares than they could otherwise afford.
- Volatility: Margin stocks can be more volatile than other investment types, so it’s important to understand the risks before investing.
- Access: Marginal stock is typically only available through brokers or banks.
|DID YOU KNOW: If you’re new to margin trading, you might not know that in order to buy stocks, you must have a margin account—a brokerage account through which a stockbroker lends you money so you can buy more securities than you could with your account’s balance.
What Is a Margin Loan?
A margin loan allows you to borrow money to invest in qualified shares or managed funds by pledging an existing asset, such as stocks or mutual funds. Your brokerage house can lend cash against the value of certain equities, bonds, and mutual funds in your portfolio, much like a bank can if you have equity in your home. Marginal loans can be used to buy extra assets, invest in cryptocurrencies, or, in some instances, for short-term demands not relating to investing.
The maximum amount you can borrow is limited by your portfolio’s securities, the loan-to-value ratio, and a credit limit based on your financial condition. Within certain margin trading limits, each brokerage firm may specify which equities, bonds, and mutual funds are marginal. The list generally includes securities listed on the major US stock exchanges that trade for at least $5 per share, although some high-risk assets may be excluded—just pay attention to which investment tools are eligible.
- The primary benefit of margin lending is that the amount you can borrow is determined by the portfolio’s assets, the loanable value, and a credit limit based on your financial position.
- Lenders can make marginal loans to individuals, investment real estate companies, private and public companies, limited liability partnerships, and other incorporated organizations.
- To get a loan, you must sign a margin agreement outlining the margin interest rates, as well as all the additional loan terms and obligations.
How Does a Margin Loan Work?
How marginal loans work seems really simple: you borrow money from your broker to buy shares of stock or invest in more securities than you could otherwise afford with your available funds. You may increase your profit potential through margin buying, but only if your investments exceed the cost of the loan itself. There’s also a certain amount of credit risk, as marginal loans may cause the investor to lose money faster than investing with cash.
As already mentioned, the amount of money you can borrow for margin investing depends on the stock value and the margin requirements set by your broker. The amount is determined by your financial position, as well as the loan-to-value ratio (LVR) of your current portfolio’s securities, which can either be shares, managed funds, or cash employed as security. The LVR is the percentage of your loan divided by the value of the stock or managed funds being used as security.
If the value of your security drops in comparison to the margin borrowing amount, you might risk going over your maximum LVR. This will result in a margin call (something we’ll get into later), and you’ll be required to decrease your loan amount, add more security, or sell a portion of your investment until your LVR is below the maximum.
For this reason, if you have a margin credit, you must pay close attention to your asset value to take action if needed. What’s essential to understand about margin is that the equity that guarantees the loan may also be used by the lender to repay it.
Your broker can also set a maintenance margin requirement, which is the minimum amount of equity you must have in your account to keep it open. For example, if the maintenance margin requirement is 30%, you must maintain at least $30 worth of equity for each $100 borrowed.
|Margin stock is any stock that can be bought and sold on a stock exchange using funds borrowed from a broker.
|Marginal loan uses securities as collateral: these can be stocks, bonds, or other assets.
|The maximum amount you can borrow is limited by your portfolio’s securities, the loan-to-value ratio, and a credit limit based on your financial condition.
|Your broker might also set a maintenance margin requirement—the minimum amount of equity you need in your account.
Pros and Cons of Marginal Loans
Like any other type of investment loan, margin loans have their own advantages and disadvantages. Let’s take a look at the advantages first:
- Competitive interest rates are typically lower than those on a credit card or personal loan.
- When you deduct investment interest expenses, you may take advantage of this loan’s tax benefits.
- Because your assets are used as collateral, you may quickly obtain cash.
- Supplying cash flow if you need money for a home repair, wedding, medical treatment, or another significant or unexpected expense.
- Instead of selling an investment for short-term capital gains, you can use a margining loan to finance a short-term need and then sell your asset once it reaches long-term capital gain status.
- Marginal loans may be a helpful short-term solution if you have a lot of capital gains in one tax year or want to spread out your earnings over several years.
Unfortunately, there are several risks that go along with margin funding, including:
- The possibility of losing more money than you put into the margin account.
- Having no right to extend the time to meet a margin call.
- Rates may rise, raising the cost of your loan.
- Your marginal securities will be sold without your knowledge if you don’t pay off a margin call.
- Even if the portfolio value falls to zero, many marginal loans are “full recourse,” meaning the borrower is responsible for repayment even if the portfolio value dips.
When Do You Have to Pay Back Margin Loans?
The good thing about this type of loan is that there’s no set payback schedule. You can pay back the principal amount on your own schedule, as long as you meet your maintenance margin requirement. Because the loan is secured by your portfolio, margin loan accounts have strict minimums. The standards may differ depending on the broker, but your cash and assets must remain above the firm’s minimum.
If the market drops and your equity falls below the minimum amount, your brokerage firm will issue a margin call (also known as a maintenance call). A margin call is when a broker demands more money or securities to raise the account back up to the minimum maintenance requirement. If you don’t comply, the company can sell your assets to satisfy the requirement.
While the market value of the securities pledged as collateral for the marginal loan fluctuates, your borrowing amount remains constant. As a result, if the shares decrease in value, your equity in relation to your margin debt will shrink.
This is important to remember since margin traders must maintain a certain amount of equity in the account as collateral for the purchased asset—typically 30% to 35%, depending on the securities and brokerage firm.
|DID YOU KNOW: The equity in your account is calculated by subtracting your marginal loan balance from the total account’s value. For example, if your account’s security value was $15,000 and your marginal loan balance was $10,000, your equity would be around $5,000, or 33%.
All things considered, buying stock on margin can provide an opportunity to increase investment exposure and potentially magnify returns. However, it’s important to be aware of the risks involved, as well as to get familiar with all the terminology set by your broker before getting started.
You can repay the loan either by putting money into your account or selling securities. Buying on margin allows you to repay the loan either by increasing the balance of your account or selling some of your marginable assets.
Without knowing how margin interests work, you wouldn’t fully understand what is margin stock. This loan’s interest is paid to the lender, which in most cases is the broker. The amount of interest you pay will depend on the amount of money you borrow and the current interest rate.
The accrued margin interests are credited daily and charged monthly. The daily interest is calculated by multiplying the settled margin debt balance with the yearly interest rate and dividing the result by 360. The annual interest rate is determined by the amount of the debit balance on that particular day.