Margin: How Does It Work?

In the same way that a bank can lend you money if you have equity in your house, your brokerage firm can lend you money against the value of certain stocks, bonds and mutual funds in your portfolio. That borrowed money is called a margin loan, and can be used to purchase additional securities or to meet short-term financial needs.

Each brokerage firm can define, within certain guidelines, which stocks, bonds and mutual funds are marginable. The list usually includes securities traded on the major U.S. stock exchanges that sell for at least $5 per share. Also, keep in mind that you can’t  borrow funds in retirement accounts or custodial accounts.

How does margin work?

Generally speaking, brokerage customers who sign a margin agreement can borrow up to 50% of the purchase price of marginable investments (the exact amount varies depending on the investment). Said another way, investors can use margin to purchase potentially double the amount of marginable stocks than they could using cash.

Few investors borrow to that extreme—the more you borrow, the more risk you take on—but using the 50% figure as an example makes it easier to see how margin works.

For instance, if you have $5,000 cash in a margin-approved brokerage account, you could buy up to $10,000 worth of marginable stock—you would pay 50% of the purchase price and your brokerage firm would loan you the other 50%. Another way of saying this is that you have $10,000 in buying power. (Schwab clients may check their buying power by referring to the “Margin Details” module on the right side of Trade pages and selecting the “Marginable Securities” option in the drop-down menu

Similarly, you can often borrow against the marginable stocks, bonds and mutual funds already in your account. For example, if you have $5,000 worth of marginable stocks in your account and you haven’t yet borrowed against them, you can purchase another $5,000—the stock you already own provides the collateral for the first $2,500, and the newly purchased marginable stock provides the collateral for the second $2,500. You now have $10,000 worth of stock in your account at a 50% loan value, with no additional cash outlay.

Because margin uses the value of your marginable securities as collateral, the amount you can borrow fluctuates day to day along with the value of the marginable securities in your portfolio. If your portfolio goes up, your buying power increases. If your portfolio falls in value, your buying power decreases.

Margin interest

As with any loan, when you buy securities on margin you have to pay back the money you borrow plus interest, which varies by brokerage firm and the amount of the loan.

Margin interest rates are typically lower than credit cards and unsecured personal loans. And there’s no set repayment schedule with a margin loan—monthly interest charges accrue to your account, and you can repay the principal at your convenience. Also, margin interest may be tax deductible if you use the margin to purchase taxable investments (subject to certain limitations, consult a tax professional about your individual situation).

The benefits of margin

A margin loan can be used to meet short-term lending needs not related to investing.  Margin can also be used for investing purposes to magnify your profits as well as your losses. Here’s a hypothetical example that demonstrates the upside; for simplicity, we’ll ignore trading fees and taxes.

Assume you spend $5,000 cash to buy 100 shares of a $50 stock. A year passes, and that stock rises to $70. Your shares are now worth $7,000. You sell and realize a profit of $2,000.

What happens when you add margin into the mix? This time you use your buying power of $10,000 to buy 200 shares of that $50 stock—you use your $5,000 in cash and borrow the other $5,000 on margin from your brokerage firm.

A year later, when the stock hits $70, your shares are worth $14,000. You sell and pay back $5,000 plus $400 interest¹ which leaves you with $8,600. Of that, $3,600 is profit.

So, in the first case you profited $2,000 on an investment of $5,000 for a gain of 40%. In the second case, using margin, you profited $3,600 on that same $5,000 for a gain of 72%.

The risks of margin

Margin can be profitable when your stocks are going up. However, the magnifying effect works the other way as well.

Jumping back into our example, what if you use your $5,000 cash to buy 100 shares of a $50 stock, and it goes down to $30 a year later? Your shares are now worth $3,000, and you’ve lost $2,000.

But what if you had borrowed an additional $5,000 on margin and purchased 200 shares of that $50 stock for $10,000? A year later when it hit $30, your shares would be worth $6,000.

In this example, if you sell your shares for $6,000, you still have to pay back the $5,000 loan along with $400 interest¹, which leaves you with only $600 of your original $5,000—a total loss of $4,400. If the stock had fallen even further, trading on margin could result in a scenario where you lose all of your initial investment and still owe the money you borrowed plus interest.

Margin call

Remember, the marginable investments in your portfolio provide the collateral for your margin loan. Remember, too, that while the value of that collateral fluctuates according to the market, the amount you borrowed stays the same. If your stocks decline to the point where they no longer meet the minimum equity requirements for your margin loan—usually 30% to 35% depending on the particular securities you own and the brokerage firm²—you will receive a margin call (also known as a maintenance call). When this happens, your brokerage firm will ask that you immediately deposit more cash or marginable securities into your account to meet the minimum equity requirement.

An example: Assume you own $5,000 in stock and buy an additional $5,000 on margin, resulting in 50% margin equity ($10,000 in stock less $5,000 margin debt). If your stock falls to $6,000, your equity would drop to $1,000 ($6,000 in stock less $5,000 margin debt).

If your brokerage firm’s maintenance requirement is 30% (30% of $6,000 = $1,800) you would receive a margin call for $800 in cash or $1,143 of fully paid marginable securities ($800 divided by (1-.30) = $1143)—or some combination of the two—to make up the difference between your equity of $1,000 and the required equity of $1,800.

Triggering a margin call

What happens if you don’t meet a margin call? Your brokerage firm may sell assets in your portfolio and isn’t required to consult you first. In fact, in a worst-case scenario it’s possible that your brokerage firm will sell all of your shares, leaving you with no shares yet still owing money.

Again, most investors choose not to purchase as much as 50% on margin as presented in the examples above—the lower your level of margin debt, the less risk you take on, and the lower your chances of receiving a margin call. A well-diversified portfolio may help reduce the likelihood of a margin call.

If you decide to use margin, here are some additional ideas to help you manage your account:

• Pay margin loan interest regularly.
• Carefully monitor your investments and margin loan.
• Set up your own “trigger point” somewhere above the official margin maintenance requirement.
• Be prepared for the possibility of a margin call—have other financial resources in place or predetermine which portion of your portfolio you would sell.
• NEVER ignore a margin call.
   

The bottom line

Buying stock on margin is only profitable if your stocks go up enough to pay back the loan with interest—and you could lose your principal and then some if your stocks go down too much. However, used wisely and prudently, a margin loan can be a valuable tool in the right circumstances.

If you decide margin is right for your investing strategy, consider starting slow and learning by experience. Be sure to consult your investment advisor and tax professional about your particular situation.

¹ Example uses a hypothetical, simple interest rate calculation at a rate of 8%. Actual interest charge would be higher due to compounding. Contact Schwab for the latest margin interest rates.

² At Schwab, margin accounts generally receive a maintenance call when equity falls below the minimum “house” maintenance requirement. For more details, see Schwab’s Margin Overview and Disclosure Statement.