How Do Margin Loans Work? - SmartAsset

Typically, margin investing works based on margin loans. These are loans that your brokerage extends so that you can purchase with a combination of your own funds and borrower money, giving you the liquidity to make larger purchases. They are secured by the assets in your portfolio and if you fail to repay the loan your brokerage will take those assets as payment. We’ll go over in full detail how it works.

A financial advisor can answer your questions, while also helping you build a financial plan for the future.

What Is Margin Trading?

Margin trading refers to when you borrow money to purchase securities. Most of the time, investors use this to buy or short stocks, since equities tend to pay their returns more quickly than most other assets.

You typically borrow the money directly from your brokerage, although occasionally investors may borrow from a third party structured as a margin loan. (For ease of use, in this piece we will refer to borrowing money directly from your brokerage.)

A margin loan is the money that your brokerage lends you to make a margin trade.

The loan is secured by assets in your portfolio. This creates two main types of margin loans: specific and general. Specific margin loans are more common. In this case, you take out the loan to make a specific trade and the loan is secured by those assets.

General margin loans are less common. Here, you don’t borrow to make a specific trade. Instead, you borrow against other assets in your portfolio to make an unrelated investment.

With general margin loans, you must own your collateral outright. You cannot use securities held on a margin as collateral against new borrowing.

Interest on Margin Loans

When you take out a margin loan, you establish a secured debt in your portfolio. This creates two ongoing obligations.

First, you assume interest. The terms on a margin loan will differ based on your specific institution and the loan itself. Almost all brokers will charge their interest on an annual rate which accrues monthly.

And it is uncommon for brokers to require regular payments. Instead, you can pay your interest along with the principal on the loan in one lump sum when you close out your position.

Interest is one of the major reasons that most margin trading is done with equities and similarly short-term assets. Since the costs will accumulate on any account, investors generally don’t want to hold their position open for too long. They want a shorter-term investment that they can cash out of more quickly.

Margin Calls

With a margin loan, the debt is secured by the value of assets in your portfolio. The more valuable your assets, the more borrowing power you have. The less valuable your assets are, the less borrowing power you have.

The result of this is that, when you take out a margin loan, your collateral will fluctuate based on its price on any given day. A basket of stocks worth $1,000, when you take out the loan, may decline to $900 in value, reducing the value of those stocks as collateral.

To address this, all brokers require you to maintain a certain percentage of value (known as “equity”) relative to the loan. Equity is the minimum value that your collateral can have relative to your loan.

Most lenders set this at around 30%. This means that the value of the assets you used to secure your margin loan cannot dip lower than 30% of the value of the loan itself (or whichever equity level your broker has set).

If your equity does fall too low, the broker will execute what is known as a “margin call.” In a call, you must bring your account back within the minimum equity. You can do this either by adding new cash or securities as collateral, or by paying off a section of your loan.

If you fail to meet your margin call, your broker can take collection actions. This means that they can liquidate the securities you used as collateral, and can insist that you repay the remainder of your loan after this sale.

Risks vs. Rewards of a Margin Loan

The advantage of a margin loan is purchasing power.

By investing with a margin loan, you can buy more assets than you could on your own. With the standard limit of 50%, for example, you can literally double your underlying investment. If you have $1,000 to invest, by using a margin loan you can purchase $2,000 worth of assets and collect the commensurate returns.

The disadvantage to a margin loan is a potentially staggering amount of risk.

The key to understanding risks in a margin loan is the idea of passive losses vs. active losses. With passive losses, your exposure is limited to the money you invest upfront. You know how much you have at stake and nobody will come along asking for more. Your worst outcome is zero.

A standard investment has a passive loss profile. If you invest $1,000 to buy a stock, you can lose up to that entire initial investment but you can’t lose more than your original $1,000.

Active losses are different. With active losses you can potentially lose more than your initial investment, leaving you further in debt after closing out the position.

Margin trading has an active loss profile. If you borrow $1,000 to buy a stock and it doesn’t pan out, you both lose your investment money and need to repay that $1,000. You can end up on the hook for debt payments even beyond your market losses.

Bottom Line

Margin loans are the money that a brokerage lends you to purchase stocks or other securities. This loan is secured by assets in your portfolio, and you generally plan on repaying it with the gains from your investment.

Investing and Retirement Planning Tips

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A 401(k) is very useful for building retirement savings. Small, regular contributions can easily add up to plenty of savings later in life. You should especially contribute to a 401(k) if your employer offers a match. If your employer doesn’t offer a 401(k), you can always invest in an individual retirement account (IRA). These work similarly to 401(k)s in that you don’t pay taxes initially on your contributions.