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Investing always involves a trade-off between risks and rewards. When you're investing on margin—investing with money that you borrow—you might be able to make more money than you would otherwise. However, you could also wind up losing your entire investment, and then some, and be forced to sell your investments at a bad time.
What Is a Margin Account?
A margin account is a type of brokerage account (investment account) that has a line of credit attached to it. Brokerage services may require you to apply for a margin account after establishing a brokerage cash account—the standard option. Once you have a margin account, you can use your account's balance as collateral to take out a loan.
Unlike opening a personal line of credit, there generally isn't a credit check when you open a margin account, and your credit score won't impact your eligibility or interest rate. With a margin account, the amount you can borrow and your rate can depend on the value of the assets in your account, how risky those assets are and your loan amount.
Initially, you may need to have a certain amount of money in the account, and you can borrow up until half the value of your account is equity. In other words, if you have $4,000 in your account, you could borrow $2,000 and invest $4,000 because 50% of that investment is your equity. Once your account is established, you may need to maintain at least 25% equity in the account—this is called your margin maintenance.
However, brokers may have in-house rules that require higher initial deposit amounts and margin maintenance requirements.
How Can Margin Investing Increase Your Risk?
Taking out a margin loan and investing the money can be risky for several reasons. The first comes from the magnified returns and losses you may receive.
For example, say you invest $2,000 in a company's stock and you sell a few months later. If the stock price increased by 10%, you would gain $200. If it decreased by 10%, you would lose $200. But what if you borrow and invest an additional $2,000?
Now you have $4,000 invested and stand to gain or lose $400. You also have to repay the loan plus interest—which could be about $55 for two months. Without margin, you would either gain or lose $200. With the margin loan and investment, you would gain $345 or lose $455.
In some situations, you might even wind up losing more than you initially invested. If the stock in the example above quickly dropped by 60% and you sold, you'd have $1,600 from the sale and still have to repay the $2,055 for the loan and interest.
There are also the additional risks that can come from using your investments as collateral for the loan. If those investments decrease in value, you may be forced to sell them or put more cash into your account. This is called a margin call.
A margin call is when the value of your account drops and you no longer have enough equity to meet the margin maintenance requirement. When this happens, the broker will ask you to deposit additional cash into your account. Or, you can sell the investments in your account until you have enough cash to meet the requirement.
While you'll often have a few days to satisfy the margin call, brokers aren't required to give you any notice and they can choose which investments to sell. If the market is crashing or volatile, you could wind up being forced to sell investments at a loss, even if you think they'll be long-term winners.
What Are the Benefits of Using a Margin Loan?
While taking out margin loans can be risky, margin accounts do offer investors several benefits:
- Quick and easy funding: There might not be a credit check, and you may be able to get the money within a few days.
- Flexibility: While many people use margin loans to buy securities, you could also take out the money as cash and use it to pay other expenses.
- Low interest rates: Margin loans tend to have lower rates than personal loans or credit cards, and they may even be lower than some other types of secured loans.
- Delayed capital gains: You might need cash today but not want to sell investments that could result in capital gains taxes. Margin loans aren't taxable income because you need to repay the money.
- No minimum payments: Interest may accrue daily, but you don't have to make payments as long as you have enough equity.
If you are going to take out a margin loan, keep the risks in mind. You might want to make sure you have enough cash in an emergency fund to satisfy most margin calls.
Less Risky Ways to Start Investing
If you're new to investing, you could also take time to become more familiar with the basic types of investment accounts and assets before opening a margin account, which is often more suited to experienced investors.
For example, you might be able to benefit from using tax-advantaged accounts, such as a 401(k) from your employer, individual retirement account (IRA) or health savings account (HSA). While you might not be able to invest as much money if you're not taking out a loan, the tax savings can help decrease your tax bill today and help you build wealth for your future.
Also, take time to learn about the different types of investments you can buy. Stocks, bonds, mutual funds, ETFs, cryptocurrencies and other assets might be good choices. But there are different risks associated with each type of investment, and understanding the risk is especially important when you're considering buying on margin.
Build Your Credit to Qualify for Better Loans
While margin loans don't require a credit check, your credit score can impact your ability to qualify for other types of loans and the interest rate you receive. Check your credit score for free with Experian, and get insight into which factors are hurting and helping your credit the most.