House maintenance requirement refers to the minimum amount of equity that a trader must have in their account to maintain a margin balance. The regulations are set out by Regulation T of the Federal Reserve as a way to protect brokerage firms from losses in the event that traders are unable to pay back the credit.
Regulation T prescribes that traders can borrow a maximum of 50% of the purchase price and fund the remaining balance using cash. It also requires that traders have at least 25% equity levels of their investment value.
Usually, brokerage firms have the flexibility to adjust their maintenance requirements provided they are more rigorous than the minimum standards set out in Regulation T. For example, brokerage firms may grant lower house maintenance requirements for their large clients, but the value must be equal to or above the 25% minimum level.
House maintenance requirement is the minimum level of equity that traders must maintain with a broker.
Regulation T of the Federal Reserve requires that traders can only borrow up to 50% of the purchase price of securities from a broker.
Brokerage firms can modify the prescribed Regulation T requirements, provided they are more rigorous than the original rules set out in Regulation T.
Understanding House Maintenance Requirements
House maintenance requirements are designed to reduce the credit risk of brokerage firms. Brokerage firms work the same way as banks, by allowing customers to buy stocks on credit against the value of securities in their portfolio. The credit borrowed is known as a margin loan, and it is used to purchase additional securities, i.e., stocks, bonds, or mutual funds, to add to the investor’s portfolio.
Traders are required to maintain equity levels of a minimum of 25% of their investment value at any time. If the equity level falls below the given point, the brokerage firm may place a margin call to the trader. The trader will be required to deposit additional security in their account with the brokerage, or the brokerage may decide to liquidate the trader’s portfolio to pay back the margin.
For example, if a trader holds $50,000 worth of securities in his portfolio, he can borrow up to 50% of the purchase price of their investments, which is equal to $100,000 worth of securities. The house requirement, in such a case, varies from 25% to 50% according to Regulation T.
However, for most brokerage firms, the requirement can be in the 30% to 50% range. If the brokerage’s house requirement is 40% and the value of collateral falls below the mark, the broker will issue a margin call. If the decline in the price of stocks causes the value of stocks to fall to $75,000, the level of equity becomes $25,000 ($75,000 – 50,000).
With the brokerage margin requirement of 40%, the trader needs to have $30,000 ($75,000 * 40%) equity in the account. This means that the trader’s equity is below the house margin requirement by $5,000, and will get a margin call for the $5,000. The trader can either deposit additional cash to boost their collateral or sell part of their shares to pay the margin.
How a Margin Account Works
A margin account is an account that traders maintain with a brokerage firm, and it allows traders to borrow money to purchase additional securities. In such a case, the broker acts like a bank, where the loan is collateralized by the securities purchased and charges a margin interest on the loan awarded.
Since the customer is using borrowed money to invest in securities, the customer stands to gain or lose depending on market forces affecting the value of securities. If the trader uses the loan to purchase stocks, and the stocks increase in value beyond the margin interest, the trader will earn a positive return.
However, if the value of stocks declines below the interest charged on margin funds, it means that the trader will need to pay interest out-of-pocket as opposed to using the returns from the investment. Still, if the equity drops below the maintenance margin level, the brokerage will issue a margin call to the investor to add more cash to top up their margin account or sell some securities to offset part or all of the difference between the maintenance margin and the value of securities.
If the trader does not fulfill the margin call, the brokerage firm can liquidate the trader’s securities or sue them for carrying a negative balance in their margin account.
The Federal Reserve’s Regulation T
Regulation T was introduced by the Federal Reserve’s Board of Governors to outline rules that govern credit provision by brokers to their customers. Customers who maintain a margin account with a brokerage can obtain credit to fund part of the purchase price of securities.
Since buying on credit exposes brokers to significant losses in case the securities suddenly decline in value, the Federal Reserve introduced a rule that limited borrowing to not more than 50% of the purchase price. The other 50% must be paid with cash to cushion brokers from large losses.
For example, If investor A plans to purchase 100 shares of Company ABC at $100 per share, bringing the purchase price to $10,000, the investor can borrow up to 50% of the purchase price – i.e., $5,000 – and pay the remaining balance with cash.
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