Borrow money to buy stocks

  • A margin loan is a type of interest-bearing loan that lets you borrow against the value of securities you already hold in a margin account.
  • Margin loans increase your purchasing power since you can buy more securities than you could with cash.
  • While taking out a margin loan can increase your earning potential, it could also magnify your losses.

When opening a brokerage account, you have two options: cash account and margin account. If you decide to open a margin account, the amount you deposit there will serve as collateral for the margin loan.

Here’s what you need to know about what a margin loan is, how these loans work, and the pros and cons of using them.

What is a margin loan?

A margin loan allows you to borrow against the value of the securities you own in your brokerage account. Whether you have stocks or bonds in your portfolio, these investments act as collateral to secure the loan.

Each brokerage firm has its own terms on margin loans and the securities it considers eligible for cover. Typically, they will have a list of stocks, mutual funds, and bonds on margin. You can use margin to leverage your account as it will increase your buying power.

How do margin loans work?

Margin buying is when you buy stocks, bonds, mutual funds, or any other market security by borrowing money from a broker. “If you’re buying on margin, you’re effectively borrowing money from a brokerage to buy stocks,” says Baruch Silverman, founder of The Smart Investor. “In simple terms, you could think of this as a loan from a broker.” When you buy investments on margin, you are essentially using your securities as collateral to secure a loan.

Most brokerage firms allow clients to borrow up to 50% of the value of securities on margin. So if you have $4,000 of margin investments in your margin account, you can borrow up to $2,000. Using margin increases your buying power because you can buy more securities than you could otherwise buy with a cash account.

Like any other loan, “margin loans charge interest,” says Cliff Auerswald, president of All Reverse Mortgage. The annual effective annual rate of interest on margin is generally lower than that of personal loans and credit cards. Additionally, “there is no set repayment schedule for everyone,” he adds. Margin loans do not require a fixed payment schedule and any interest charged is applied monthly.

Advantages and disadvantages of margin loans

Advantages

Using margin has several potential benefits, including:

  • Increase in purchasing power. A margin loan allows you to buy more investments than you could otherwise buy with a cash account. Let’s say you want to buy 100 shares of a specific company, but you have less money in your brokerage account. When you use margin, you leverage your account to buy more investments.
  • Easy access to funds. With a margin account, you can access cash without having to sell your investments. Your brokerage can give you instant access to funds, which you can repay at your convenience by depositing cash or selling securities.
  • Allows you to diversify your portfolio. A margin loan gives you more buying power, which means you can buy more different securities like stocks, bonds, mutual funds, and exchange-traded funds. A diversified portfolio translates into a lower risk investment.
  • You can repay the loan by depositing cash or selling securities. Buying on margin allows you to repay the loan by adding more money to your account or selling some of your investments on margin.
  • There is no set schedule for loan repayment. The advantage of a margin loan is that you can repay the principal at your convenience, provided you meet your maintenance margin requirement.

The inconvenients

Like any other financial tool, margin loans also have drawbacks.

  • You may be faced with a margin call or stock liquidation. Margin accounts have a minimum maintenance requirement, and if not maintained, you may be subject to a margin call. A margin call is an alert from your broker to load more money into your account, sell investments, or add more assets on margin. If you fail to respond to a margin call, your broker may take prompt action to liquidate the securities in your account.
  • Interest rates may increase. Margin loans carry interest, but generally have lower rates than other forms of lending. But if you don’t pay the interest on your margin loan for a long period of time, interest rates can go up, which can lead to an increase in the cost of your loan.
  • You may incur losses if the value of the securities in your account declines. While a margin loan can increase your potential returns, the reverse is true – it can also magnify your losses. When the securities in your portfolio lose value, your losses increase. It is even possible to lose more than your initial investment.

The bottom line

A margin loan allows you to borrow against the securities you own in your brokerage account. Buying on margin increases your buying power since you can buy more investments than you could otherwise buy with cash. While margin can increase your potential returns, it can also magnify your losses. Plus, even if you’re right with your trades, interest charges can eat into your profits.

Generally speaking, buying on margin is very risky and you can lose more than your initial investment, especially if you are inexperienced. If you decide to take out a margin loan, be sure to weigh the benefits and risks.