Most investors buy and sell stocks, bonds and other securities using the assets in their brokerage accounts. Sometimes, investors want to be able to withdraw money from their accounts without actually selling any of their investments. Investors can accomplish this by borrowing against their portfolios. This is known as margin debt. There are many reasons to borrow, rather than sell your assets, including to avoid triggering a taxable event and to keep their money invested in a growing market. In this article, we’ll define what margin debt is, how much you can borrow and how investors use it.
Borrowing from your investment account can be risky so it’s always a good idea to work with a financial advisor, especially if such debt is new to you.
What Is Margin Debt?
Margin debt is the amount of money that an investor has borrowed against their investment portfolio. This allows your investments to continue to perform within the market while providing liquidity to pay off debt, purchase other investments or spend any way you wish. Many brokerage companies offer margin debt against non-taxable investments for their established customers.
However, federal law does not allow investors to take out a margin loan against funds in IRAs and other retirement accounts. This is due to the IRS prohibiting IRA funds to be used as collateral. If you do take out a loan against your IRA, the IRS will consider it a distribution, and taxes and early withdrawal penalties may apply.
How Much Can You Borrow With a Margin Account?
Each brokerage company has its own limits on margin debt and the amount you can borrow depends on the type and value of your eligible securities. Lightly traded securities and those whose values are volatile may have lower margin percentages.
If you are using margin to purchase a security, FINRA requires investors to deposit at least $2,000 or 100% of the purchase price of an asset, whichever is less, before you can trade. This is known as the “minimum margin.” Depending on your brokerage company, their minimum deposit amount may be higher.
Additionally, the Federal Reserve’s Regulation T requires that investors borrow no more than 50% of an asset’s purchase price. This is known as the “initial margin.” The other 50% must come from cash within the investor’s brokerage account. Not all securities can be purchased on margin, so contact your brokerage company to ensure that the investment you want to make is eligible.
When borrowing against your portfolio to pay off debt, get cash for emergencies or other reasons, most brokerages limit your initial margin to 50% of your portfolio’s value.
What Is a Margin Call?
A margin call happens when your margin debt is too high compared to the value of the investments that are securing that loan. FINRA regulations require that investors keep at least 25% equity in their margin account. This means that the loan cannot be higher than 75% of the portfolio’s value. When the assets securing the loan drop in value too much, a margin call can be triggered. Usually, the brokerage company requires an investor to add money to the account within a certain timeframe. If the investor fails to do so, or the assets drop even further, then the brokerage company may sell the assets to bring the equity back to its limits.
However, there is no requirement that the brokerage company allow you to deposit more money before they sell the security to cover the drop in value. They may be able to sell your investment securities at any time without consulting you first.
How Do Investors Use It?
Investors typically use margin debt for two reasons, to trade securities or get cash without selling their investments.
- Trading securities – Investors use margin debt to borrow up to 50% of the purchase price of an investment. This allows investors to use leverage to buy more than what the cash in their account would normally enable them to purchase.
- Get cash without selling investments – Some investors need cash to reduce their debt, cover bills or other purposes. Borrowing against their investments allows them to meet their current needs while continuing to participate in the market.
- Avoid taxes on their gains – When an investor borrows against their investments to use the cash, they avoid paying capital gains on the money withdrawn. This is especially helpful when you can delay selling short-term holdings until they qualify for long-term capital gains.
What Should You Watch Out for?
When taking on margin debt, you have to be careful because your losses could be magnified greatly. Normal investors can only lose the value of their investments. Investors who borrow on margin can actually lose much more than the value of their investment portfolio.
- Volatility in the market – While the stock market tends to increase over time, the stock market normally fluctuates 5% to 10% each year and there have been more than 10 instances of a 20% drop since World War II. These short-term drops in value can affect entire sectors of the market, even if your investments have done nothing wrong.
- Stocks that fluctuate wildly – Even when the market is trading within normal patterns, individual securities could go up and down in value quickly. News about the company, its competitors or the industry
- Margin calls – If your loan amount gets too high compared to the value of the assets securing the loan, you may have to sell assets or add more money to your account to satisfy margin requirements.
The Bottom Line
Margin debt can be a useful tool to purchase additional securities or tap into the value of your portfolio. Most brokerage companies will allow you to borrow up to 50% of the value of an asset. If the value declines, you must maintain at least 25% equity, otherwise, you’ll experience a margin call. This means that your investments can be sold without your permission. While margin debt provides opportunity, it is not without its risks. Investors should tread carefully when using this strategy.
Tips on Investing
- Consider working with a financial advisor as you explore ways to leverage your existing investment assets to boost portfolio performance. Finding a financial advisor doesn’t have to be hard. SmartAsset’s matching tool can connect you with several in your area within minutes. If you’re ready, get started now.
- Asset allocation is a key element for investors to review when it comes to balancing the risk of their portfolios. Those with ample disposable income might choose a riskier asset allocation. Conversely, someone nearing retirement age may want to be more conservative. SmartAsset’s asset allocation calculator can help you figure out the allocation that makes the most sense for you.
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