Margin Accounts Unraveled: Evaluating the Worthiness of Their Associated Risks

**What are Margin Accounts?**

A margin account is a type of brokerage account that allows investors to borrow cash from their broker-dealer to purchase securities or fulfill other short-term financial needs. This borrowing is known as a margin loan, with the investor’s portfolio serving as collateral for the loan. Interest is charged on the borrowed amount, although margin loan rates tend to be lower than rates for credit cards and personal loans. There is typically no specified repayment timeline, allowing investors to pay back the loan at their convenience. According to Federal Reserve Board Regulation T, investors can borrow up to 50% of the purchase price of new marginable investments. However, the exact amount may vary based on the specific security.

**How Margin Accounts Work**

Let’s say an investor has $10,000 in cash in their brokerage account and decides to borrow an additional $10,000 from their broker to buy $20,000 worth of stock shares. Over the course of a year, the value of those shares increases by 40%, raising the investment value to $28,000. As a result, the equity in the investor’s account (securities value minus the loan amount) grows from $10,000 to $18,000—an 80% increase. It’s important to note that there may be rules and limitations in place that dictate borrowing limits and required account balances. If the value of the securities falls below a certain threshold, the brokerage may require the investor to deposit funds or sell securities to increase the account’s value.

Furthermore, each brokerage has its own set of rules regarding eligible marginable securities. Typically, most securities listed on the New York Stock Exchange (NYSE) and NASDAQ that trade at a minimum of $5 per share, as well as mutual funds owned for over 30 days, approved OTC stocks, and certain bonds, can be used as collateral. However, securities held in retirement accounts such as a 401(k) or IRA are not eligible for margin accounts. Additionally, certain high-risk investments may not be marginable.

**Pros and Cons of Margin Accounts**

Margin accounts offer increased buying power, which allows investors to acquire more shares than they could with cash alone. For those with limited initial capital, this can be an attractive way to diversify their portfolio and generate higher returns over time. Margin accounts can also serve as a flexible, secured line of credit for non-investment purchases.

However, there are risks associated with trading on margin. One such risk is the possibility of receiving a margin call. A margin call occurs when the value of an investor’s account falls below the brokerage’s maintenance margin. In response to a margin call, investors must either add cash to their account or sell securities to cover the shortfall within a short timeframe. Failing to meet the margin call requirements may result in the brokerage selling off shares, leading to losses.

Another risk is the potential for larger losses. While investing on margin can amplify returns during market upswings, it can also magnify losses if investments lose value. For instance, if the previously mentioned $20,000 investment drops by 50% to $10,000 while still owing the brokerage $10,000 for the margin loan, this would result in a 100% loss, plus interest and commissions.

**Determining Suitability for Margin Accounts**

Considering the risks involved, it is essential to evaluate your financial situation and long-term investment strategy before opting for a margin account. While eligibility requirements vary among brokerages, there are several factors to consider:

1. Emergency Fund: Prioritize building an emergency fund in a high-yield savings account before allocating extra cash to investments.

2. High-Interest Debt: Pay off any debt with high interest rates before directing additional funds to a brokerage account, as high debt balances can negate investment returns.

3. Retirement Savings: Ensure that retirement savings are on track before engaging in stock market investing. Note that margin trading is not permitted in retirement accounts, so prioritize maximizing contributions to tax-advantaged 401(k) or IRA accounts.

If these considerations are met, investing on margin may be worth exploring. However, it is crucial to limit exposure to speculation and reduce the risk of margin calls. Personal financial planner Brian Walsh suggests investing no more than 5% to 10% of an individual’s total investment portfolio in speculative investments like margin trading, cryptocurrency, derivatives, or land. Additionally, margin exposure should be kept low enough to avoid the risk of a margin call, unless the investor has ample cash reserves to cover it.