What is Margin Debt?
Margin debt represents the amount that an investor owes a broker in their margin account. When a broker approves a margin account for an investor, the margin account is granted a line of credit that can be used to purchase securities. The brokerage charges an interest rate on the margin debt, and these interest charges are applied automatically to the margin account balance.
The New York Stock Exchange (NYSE) publishes monthly margin debt statistics for all transactions on the trading platform.
- Margin debt is the sum of money that investors borrow from the brokerage through the margin account.
- Investors can use the margin debt to buy securities or short sell stocks.
- The initial set margin debt that the investor can borrow is 50% of the total account balance.
Understanding Margin Debt
Brokerage firms do not impose a repayment plan for margin debt, but investors are required to maintain a certain amount of equity in the margin account. An investor who trades on margin must ensure that the purchased securities earn a high return that is above the interest charged on the margin debt.
The margin debt accumulated in a margin account directly impacts the profits earned by an investor. When the stock value falls below the maintenance margin, the investor incurs a loss until the margin is restored back to the minimum level – the investor’s securities and cash deposits in the margin account act as collateral for the margin debt.
How It Works
When an investor buys stocks using borrowed money from a brokerage, he/she incurs a margin debt. Buying stock on margin means that the investor used borrowed funds and their cash deposit to purchase additional securities. A margin debt allows the investor to buy more securities using their brokers’ funds compared to the number of securities they would’ve purchased using cash only.
Investors are required to maintain an equity value that is above the maintenance margin to avoid getting a margin call. If the equity value of securities falls below the minimum margin, the brokerage will issue a margin call. The margin call requires the investor to top up the margin account by depositing more funds to meet the minimum margin requirement. The brokerage does so to reduce the risk of the investor defaulting on the margin loan.
Importance of Margin Debt
In the current financial market, investors are seeking solutions to help them leverage their investments to maximize gains. Margin debt provides an investor with extra funds to make larger investments using their money together with borrowed money from brokers.
Buying securities on margin debt can quickly improve the investor’s returns by investing in high-potential securities. It enables the investor to realize profit within a short period. Before using a margin account to purchase securities, the investor needs to understand the risks and limitations of trading with margin debt.
Pros of Margin Debt
Trading with a margin debt allows the investor to make a profit using borrowed money. The accumulated profit can be channeled to other investments, thus giving the investor an opportunity to diversify their returns.
The expected scenario when trading using margin debt is that potential returns are greater than the anticipated risks. An investor may also use the margin debt to short sell. During short selling, an investor borrows a security from the broker and sells it in the financial open market, with an expectation to buy it later at a lower price.
Cons of Using Margin Debt
The investor’s equity in the margin account is determined by taking the invested stock value minus the margin loan value. If the stock’s value depreciates, the investor’s equity will fall by the same or higher value. For example, a 50% drop in the value of stock purchased with margin debt can result in an equivalent or higher loss in the value of the investor’s equity.
If the equity value of securities declines below the required margin level, the investor is required to top up the account to meet the required minimum balance. Injecting more cash into the margin account is a loss to the investor since the funds could be invested in other ways to earn a return. If the investor does not respond to the margin call, the brokerage can force-sell part of the securities in the investor’s margin account to offset the margin debt.
When using margin debt to trade stocks and other securities, an investor has an opportunity to earn double the return on stocks that appreciate. The securities purchased using margin debt may increase the potential returns of the purchased securities.
An investor can use $5,000 to purchase securities worth $10,000, with the other $5,000 being borrowed money from the brokerage. If the securities appreciate to $13,000, the investor will have earned a profit of $3,000 after paying off the margin debt.
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