The term “margin” refers to the amount deposited with a brokerage when borrowing money to buy securities. When an investor buys securities on margin, it means they are using borrowed money from the brokerage to invest in securities.
In such a case, the broker acts as the lender; the investor acts as the borrower and must prove collateral for the loan in the form of cash deposits and purchase securities. Customers earn a return on the invested capital if the purchased securities appreciate in value. However, if the value of securities depreciates, the investor will incur a loss.
The term “margin” comes with other meanings in accounting, lending, and mortgages. In accounting, the margin is used to refer to the profit generated from a sale after accounting for costs. In lending, margin represents the difference between the funds borrowed from the lender and the value of the collateral provided as security for the loan. Margin is also used in mortgages to refer to the portion of interest rate that is added to the adjustment-index rate of an adjustable-rate mortgage.
Margin represents the amount of money that investors can borrow from a brokerage to purchase financial products such as stocks and bonds.
Buying on margin allows investors to earn higher returns than they would otherwise have when buying securities using cash only.
When buying on margin, the investor provides cash deposits and purchased securities as collateral for the margin loan.
An investor buys on margin when he/she uses borrowed money from a brokerage to purchase securities. For an investor to access a margin loan, they must keep a margin-approved account with the brokerage.
The margin-approved margin account is structured differently from a standard brokerage account, and it allows investors to access credit facilities from the brokerage. The cash deposited into the account and all securities in the investor’s portfolio act as the collateral for the loan. The broker uses the value of the collateral provided to determine the amount of margin available to an investor.
The broker charges a periodic interest rate on the amount of loan provided, and the investor must pay the interest due. The investor stands to gain from a margin account if the purchased securities earn a higher rate of return than what the investor paid the broker as interest for the loan.
Buying on Margin
Before opening a margin account, brokers are required to obtain consent from the investor. Once the account is opened, the investor is required to make an initial deposit of $2,000 or higher, which is known as the minimum margin.
The investor can then start using the account for share trading and can borrow up to 50% of the capital required to purchase a security. The investor must deposit the initial margin to pay the other 50%. The investor can maintain the margin account in the long term, as long as they pay interest on the borrowed funds.
For example, assume that John makes a deposit of $2,000 in his margin account and is interested in buying 700 shares of Company ABC that are currently trading at $5 per share. He can use his initial margin to purchase 400 shares of Company ABC at $2,000 (400 x $5) and borrow $1,500 from the broker to purchase an additional 300 shares.
If Company ABC shares appreciate to $10 per share, it means that John’s share will be worth $7,000. On the downside, if the share price drops to $3 per share, John’s shares will be worth $2,100. It means that he will have incurred losses, and he will need to deposit more cash into the margin account to pay the loan and interest and still maintain his minimum margin.
Maintenance Margin Requirement
Maintenance margin is the minimum amount of equity that investors must maintain in their margin account. The Federal Reserve’s Regulation T sets the maintenance margin at 25%, but brokerages can set a higher rate to protect themselves from customer defaults.
The amount of equity must exceed the maintenance margin, and if a decline in the value of the securities causes the equity to fall below the required margin, the brokerage will issue a margin call. If the investor does not respond to the margin call, the brokerage can close any open positions or sell part of the securities to increase the margin to the required value. The brokerage may also charge a commission for the activity performed to meet the maintenance margin.
Interest on Margin Account
When an investor borrows funds from a brokerage to buy securities, they are required to pay interest on the funds provided. The interest is charged as a percentage of the loan, and it is applied automatically to the account balance.
An investor may also choose to make interest payments to the brokerage instead of having the interest deducted from their margin account. If the investor does not pay off the loan and the required interest on time, the debt and interest charges will accumulate over time. It may limit the investor’s ability to earn enough returns in the future. Margin accounts are used as short-term investments that investors can use to profit from short-term security movements rather than long-term investments.