Brokerage accounts can be either cash accounts or margin accounts. With cash accounts, investors have to pay the full cost of any securities, usually within three days. Margin accounts, on the other hand, let investors borrow part of the cost from the broker. By buying on margin, investors can acquire more securities and potentially increase returns. They can also lose more, up to and more than the initial investment. Cash accounts offer opportunities for more limited profits but are less risky.
Consider working with a financial advisor as you set up or make changes to your brokerage account.
Understanding Cash Accounts
If you have a cash account with your broker, you can only use funds in the account to pay for purchases of stocks, bonds and other securities. This means paying in full for any trades as soon as they settle, usually within three days of the trade date.
Having a cash account also means you have to pay for investment securities before selling them. If you sell a security before paying for it, your account may be frozen by your broker for violating Regulation T of the Federal Reserve board, which prohibits “freeriding,” among other practices.
If your account is frozen, you have to pay in cash on the date of the trade for any purchases of investments. You can’t wait three days. You can still use the account, so it’s not totally frozen.
Understanding Margin Accounts
With margin accounts, investors aren’t limited to the funds in their brokerage accounts. Instead, they borrow funds from their brokers to make securities purchases. This lets them buy securities worth more than they have in their accounts. The assets in the account, including cash and securities, serve as collateral on the loan.
A number of rules from different regulators govern margin accounts. One from FINRA, the financial industry self-regulatory organization, concerns minimum margin. The minimum margin rule requires an investor to deposit at least $2,000 or 100% of the cost of the securities being purchased, whichever is less, before buying on margin.
Initial margin is part of the Securities and Exchange Commission Regulation T. This rule limits the amount an investor can borrow to 50% of the cost of the securities being purchased. Some brokers have stricter initial margin rules. These rules mean an investor may have to deposit additional funds before buying on margin.
FINRA also specifies a maintenance requirement on margin accounts. This sets the minimum amount of equity an investor must have in the account. Equity equals the value of cash and securities in the account minus amounts owed the broker. Equity must be at least 25%. Some brokers have higher maintenance requirements.
Like other lenders, brokers charge interest on loans. This cost reduces returns by the amount of the interest, which can vary widely among brokers.
Brokers also can institute a margin call on a margin account experiencing losses. This lets the broker sell securities from the account to build up the account’s cash balance to reach the minimum. Brokers can sell securities to meet a margin call without the investor’s permission.
Brokerages may use margin accounts as the default for new accounts. This means an investor may not know he or she is opening a margin account. Check the account application carefully to see that you are getting the type of account that you want.
Cash Account Pros and Cons
Less risk is one benefit of cash accounts. Cash account investors have the peace of mind that comes from knowing they can’t lose more than their initial investment. Another benefit is that brokers cannot lend shares held in cash accounts. Many brokers actively lend shares in margin accounts. Dividends still go to the investor who owns loaned shares, but the investor loses the right to vote those shares.
The major drawback of cash accounts is the limit on profit opportunities. Borrowing to buy shares increases leverage, which can significantly boost returns. For instance, if a cash investor spends $2,000 to buy 100 shares at $20 and the shares increase $10 to $30, the investor gets a return of $10 times 100 or $1,000. That is a 50% return on the $2,000 cash investment.
A margin investor could commit the same $2,000 in cash and, by borrowing another $2,000 from the broker, purchase 200 shares. Then if shares rose $10 the investor would get a return of $2,000, for a 100% return. This does not account for interest on the loan. But even after paying borrowing costs a margin investor can get much higher returns.
Cash account also have limited ability to trade futures. Futures trading normally requires a margin account. Cash account investors may be able to use options by buying calls and puts. However, they generally cannot sell options unless they have enough shares or cash to meet their commitments if options get exercised.
Margin Account Pros and Cons
As noted, margin accounts can greatly increase returns by buying securities with borrowed money. But margin accounts can also amplify losses.
For example, consider that investor who bought 200 shares at $20 using a $2,000 margin loan. If the shares decline to $10, the 200 shares are now worth only $2,000, the same amount owed on the loan.
If assets in a margin account drop in value to near the amount of money owed, a broker will typically require the investor to put in more cash. If the investor can’t or won’t, the broker will sell shares at the current price. In this example, that would lock in a $10 per share loss of $2,000.
By comparison, a cash account investor who spent $2,000 to buy 100 shares would only have lost $1,000. Equally important, the cash investor still owns the shares. That means a chance of recovering the loss if share prices rise.
Other cons to margin accounts include the cost of interest, the possibility of shares in the account being loaned and, if an investor is classified as a day trader, even stiffer margin requirements. Terms of margin accounts vary widely, so investors are advised to read them carefully before opening a margin account.
The Bottom Line
Cash accounts let investors buy shares only up to the value of the money in the account, while margin accounts permit borrowing from brokers to buy more shares. Margin accounts are riskier. They can increase profits and also increase losses, including causing investors to lose more than their initial investments. Cash accounts are safer, but mean investors may have to accept fewer robust returns.
Tips on Investing
- Choosing between cash or margin account calls for careful assessment of risk tolerance and financial goals. A financial advisor can help with this decision. Finding one doesn’t have to be difficult. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- When investments pay off, you will need to figure out how much you owe in taxes. SmartAsset’s capital gains tax calculator will help you estimate how you will be taxed in your location.
- If you don’t have a lot of money to invest, you might also consider a robo-advisor online, which offers lower fees and account minimums than traditional financial advisors.
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