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What Is a Margin Account and How Does It Work?

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What is a margin account?

Spotted a hot stock and can’t afford to invest as much as you’d like? A margin account allows you to borrow money from your brokerage firm to make the buy. But if trading money you don’t have sounds risky, that’s because it is. Investing with a margin account can amplify both gains and losses. Discover the pros and cons of a margin account and whether you should add a margin account to your investment portfolio below. 

Margin Account Basics

What is a margin account?

Brokerage firms offer margin accounts to customers who want to boost their buying power or meet their short-term financial needs. Essentially, they’re loans that allow you to purchase more securities than you could on your own. As with any loan, you will owe interest. Different firms may charge different amounts based on the amount you owe and how long you hold the funds.

In most cases, you can borrow up to 50% of the price of the securities you plan to invest in. Put differently, a margin account enables you to double your investment in a particular security. That being said, some firms dictate what types of investments you can purchase with a margin account, whether it be stocks, bonds, or mutual funds. Typically, the list includes securities trading on the major stock exchanges worth at least $5 per share. 

No matter what security you choose, you must keep a minimum amount of cash in your account. Known as a maintenance margin, the Financial Industry Regulatory Authority requires customers keep  at least 25% of the value of their investments in their account. Brokers and firms may set stricter maintenance margins based on the security’s volatility. 

The Benefits

So why borrow to invest money you don’t have? Primarily because you can earn higher gains. If the value of a security you’ve invested in rises, you will earn more than if you had invested only your own funds. To make a profit, though, you’ll have to earn more than the interest you owe your firm for the loan. 

Margin accounts also allow you to take advantage of market opportunities even when you don’t have tons of cash on hand. You can invest more, and diversify your portfolio further. Another advantage you wouldn’t have with a cash account? The ability to short a stock, which means borrowing shares from a brokerage firm that you agree to return by a certain deadline, selling them immediately, then buying them back once the share price decreases, returning them to the firm and pocketing the difference.

Potential Downfalls

What is a margin account?

Just as margin accounts can magnify your returns, they can magnify loss. In fact, you will suffer a greater loss than you normally would when a stock performs badly because you’ll still owe interest to your broker. In other words, your loss is not limited to the value in your account. This makes margin accounts riskier than cash accounts.

Margin accounts may also come with unexpected margin calls, where a firm requires you to pay up because your equity in the margin account has fallen below the maintenance margin. In that case, you can either sell some of your securities or deposit more assets into the account. Firms usually give two to five trading days to meet the call, but they may give a shorter window as they see fit.

If you don’t meet a call, the firm can liquidate securities and other assets from your account to make up for the deficit. Brokers are not required to call you before the sale, and can typically select whichever securities they want to sell. In extreme circumstances, you may owe more than your securities can cover so you’ll have to sell the entire account and still pay up.

Keep in mind that a firm can adjust the required maintenance margin at any time without letting you know. This is how brokers balance their risk. Plus, shorting a stock can go badly. Even though you’re betting on the security to lose value, it may not. If it increases in value, you will lose money when you purchase the borrowed stocks back and return them to the broker.

Final Word

Margin accounts are a complicated investing tool that carry great market risk. To turn a profit, your investments must grow enough to pay back the loan with interest. When used prudently to capitalize on the right opportunity, you can earn much higher returns than you would with a cash account. On the other hand, you could experience a major loss and end up owing more than the principal amount to your broker.

Experts suggest that only experienced traders and investors use margin accounts. Some brokers actually won’t allow you to buy on margin unless you have opened a large account or have a history of stable portfolio performance. Should you choose to invest with a margin account, it’s best to conduct extensive research on the security you’re hoping to invest in. Wherever possible, leave enough cash in your account to handle market fluctuations so you avoid a margin call.  

Investing Tips
  • A financial advisor can help you determine whether a margin account is right for you. Find an advisor who meets your needs with SmartAsset’s free tool, which matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • Everyone should prioritize saving for retirement. Before you consider investing with margin accounts, mutual funds and ETFs, give your 401(k), 403(b), 457(b) and IRA some love. And if securities investments seem risky, you can always park your funds in a high-interest savings account or CD.
  • Don’t forget about investment income when tax time rolls around. SmartAsset’s capital gains tax calculator can help you determine how much you’ll owe Uncle Sam so you can develop a smart strategy for lowering your tax liability through methods like tax-loss harvesting. And if you do invest with margin accounts, ask your accountant whether your margin account interest is tax deductible against your net investment income.

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The post What Is a Margin Account and How Does It Work?   appeared first on SmartAsset Blog.

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