Margin: How Does It Work?

In much 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. Such funds are called a margin loan, and you can use them to buy additional securities or even for short-term needs not related to investing.

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, though certain high-risk securities may be excluded. Investments in retirement accounts or custodial accounts aren't eligible.

Brokerage customers who sign a margin agreement can generally borrow up to 50% of the purchase price of new marginable investments (the exact amount varies depending on the investment). As we'll see below, that means an investor who uses margin could theoretically buy double the amount of stocks than if they'd used cash only. Most investors borrow less than that because—the more you borrow, the more risk you take on—not to mention the interest costs you'll have to pay—but 50% makes for simple examples.

For example, if you had $5,000 cash in a margin-approved brokerage account, you could buy up to $10,000 worth of marginable stock: You would use your cash to buy the first $5,000 worth, and your brokerage firm would lend you another $5,000 for the rest, with the marginable stock you purchased serving as collateral.

The total amount you can deploy using margin is known as your buying power, which in this case amounts to $10,000. (Schwab clients may check their buying power by clicking on the "Buying Power" link at the top of the Trade page on Schwab.com).

New securities aren't the only source of collateral. You can also 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 as the value of the marginable securities in your portfolio rises and falls. If the value of your portfolio rises, your buying power increases. If it falls, your buying power decreases.

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 those on credit cards and unsecured personal loans. 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 and you itemize your deductions (subject to certain limitations; consult a tax professional about your individual situation).

When used for investing, margin can magnify your profits—and your losses. Here's an example of the potential 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 has risen to $70. Your shares are now worth $7,000. You sell and realize a profit of $2,000.

Here's what happens when you add margin into the mix. As we saw above, $5,000 in cash gives you buying power totaling $10,000—your existing cash, plus another $5,000 borrowed on margin from your brokerage firm—allowing you to buy 200 shares of that $50 stock.

A year later, when the stock hits $70, your shares are worth $14,000. You sell and pay back $5,000, plus $400 of interest,¹ 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%.

Margin can magnify profits when the stocks that you own are going up. However, the magnifying effect can work against you if the stock moves the other way as well.

Imagine again that you used $5,000 cash to buy 100 shares of a $50 stock, but this time imagine that it sinks to $30 over the ensuing year. Your shares are now worth $3,000. If you sell, 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. If you sold for $6,000, you'd still have to pay back the $5,000 loan and $400 interest, leaving you with only $600 of your original $5,000—a total loss of $4,400.

If the stock had fallen even further, you could theoretically lose all of your initial investment and still have to repay the amount you borrowed, plus interest.

While the value of the stocks used as collateral for the margin loan fluctuates with the market, the amount you borrowed does not. As a result, if the stocks fall, your equity in the position relative to the size of your margin debt will shrink.

This is important to understand, because brokerage firms require that margin traders maintain a certain percentage of equity in the account as collateral against the purchased securities—typically 30% to 35%, depending on the securities and the brokerage firm.²

If your equity falls below the minimum because of market fluctuations, your brokerage firm will issue a margin call (also known as a maintenance call), and you will be required to immediately deposit more cash or marginable securities in your account to bring your equity back up to the required level. 

So, assume you own $5,000 in stock and buy an additional $5,000 on margin. Your equity in the position is $5,000 ($10,000 less $5,000 in margin debt), giving you an equity ratio of 50%. If the total value of your stock position falls to $6,000, your equity would drop to $1,000 ($6,000 in stock less $5,000 margin debt) for an equity ratio of less than 17%.

If your brokerage firm's maintenance requirement is 30%, then the account's minimum equity would be $1,800 (30% of $6,000 = $1,800). Accordingly, you would be required to deposit:

• $800 in cash ($1,000+$800=$1,800), or
• $1,143 of fully paid marginable securities (the $800 shortfall divided by [1 –the .30 equity requirement] = $1143), or
• Or some combination of the two. 

• Margin loans increase your level of market risk.
• Your downside is not limited to the collateral value in your margin account.
• Your brokerage firm may initiate the sale of any securities in your account without contacting you, to meet a margin call.
• Your brokerage firm may increase its "house" maintenance margin requirements or remove specific securities from the marginable list at any time and is not required to provide you with advance written notice.
• You are not entitled to an extension of time to meet a margin call.

What happens if you don't meet a margin call? Your brokerage firm may close out positions in your portfolio and isn't required to consult you first. That could mean locking in losses and still having to repay the money you borrowed.

Again, these examples are based on 50% margin debt is the maximum you can borrow. If your debt is lower, you also decrease your risk of receiving a margin call. A well-diversified portfolio may also help make margin calls less likely, as you would avoid the risk of having a single position drag down your portfolio.

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, equity, and margin loan. 
• Set up your own "trigger point" somewhere above the official margin maintenance requirement, beyond which you will either deposit funds or securities to increase your equity. 
• 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.

Buying stock on margin is only profitable if your stocks go up enough to pay back the loan with interest. But 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.