Margin loans allow investors to buy stocks on credit, with the brokerage firm providing a loan based on the difference between the market value of the shares and the amount borrowed. Interest is charged daily and the securities are held as collateral. A minimum margin is required to open an account, and investors can borrow up to 50% of the stock price. Falling stock prices can trigger a margin call, requiring additional funds to maintain the minimum margin. While margin loans can provide leverage, they can also cause financial hardship if stock prices fall.
A margin loan or margin account is a loan made by a brokerage firm to a client that allows him or her to buy stocks on credit. The term margin itself refers to the difference between the market value of the shares purchased and the amount borrowed from the brokerage. Interest on the margin loan is generally calculated on the outstanding balance daily and charged to the margin account. As time passes, the outstanding debt increases and interest accrues. In addition, the brokerage holds the securities as collateral for the loan.
A simple example of a margin call might be an investor buying stocks with a market value of $10,000 but only using $5,000 of his own money. The other $5,000 would be provided by the brokerage as a margin loan.
It 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 that amount could be higher, depending on the brokerage firm’s own rules for opening the account. This set amount is known as the “minimum margin”. Once your account is open, you can borrow up to 50% of the price of any stock you wish to purchase. Understand, you don’t have to borrow the full 50%; the amount you borrow can be less than 50%. The 50% “down payment” is called your initial margin. As long as stock prices hold steady or rise and you make your interest payments, your life will go on smoothly.
However, you should take into account what is known as the “maintenance margin”, in case the stock prices go down. In accordance with the rules of the New York Stock Exchange (NYSE), anyone buying shares on margin must maintain a minimum of 25% of the total market value of the securities in the margin account. Some brokerage firms require an even higher percentage.
Falling stock prices could bring your account below the minimum threshold and the brokerage will require you to bring in more cash or securities to bring your holding down to the minimum. The call from the brokerage that demands 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 the maintenance minimum.
Without a doubt, margin accounts allow an investor to gain control of a large block of shares with minimal investment. Sophisticated investors will use a margin loan to increase their personal wealth by using the “leverage” provided by using borrowed money.
However, if stock prices go the wrong way, the investor with the margin loan is not only responsible for the money borrowed but also maintains his or her minimum margin account. Now, the leverage is working in reverse and falling stock prices combined with the outstanding margin loan can cause significant financial hardship for the investor.
Smart Asset.
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