A margin account refers to a type of brokerage account that investors use where they can borrow funds to purchase financial products. Investors are required to pay a monthly interest rate on the amount borrowed from the brokerage.
A margin-approved account increases the customer’s power to purchase more securities, such as stocks and bonds in the financial market. A margin account may also be referred to as a loan account owned by a broker and can be used for trading stocks.
The concept of margin account lending started in the late 1800s as a way of financing railroads. By 1920, brokers required investors to deposit a small sum of money into their account to access credit facilities. The situation’s changed over the years, with brokerages requiring investors a credit limit of up to 50% of the investor’s equity. Regulation T of the Federal Reserve requires brokerages to maintain a credit limit of at least 25% of the investor’s equity value.
A margin account is a type of brokerage account that allows customers to borrow and invest in stocks and other types of securities.
The broker uses the investor deposit and purchased financial products as collateral for the margin debt.
A margin account increases the investor’s purchasing power but can also expose them to larger losses.
Understanding Margin Accounts
Investors use margin accounts to increase their purchasing power by buying more securities than they would’ve bought using their cash deposits. Generally, a margin account is an account that investors use to access credit facilities from their brokers, which they can use to buy additional securities (called leverage) and profit from an appreciation in the value of the purchased securities.
However, using margin account funds to buy securities carries additional risk, and investors may incur larger losses if the purchase securities depreciate in value below the minimum balance requirements. The broker also charges an interest rate on the borrowed funds, and the investor is required to pay the interest charges as they come due. The fees are applied automatically to the customer’s account.
Opening a Margin Account
When a broker approves a margin account, the broker essentially provides a credit line to the investor that can be used to invest in stocks, bonds, and commodities. The securities purchased and the cash deposited by the investor serve as collateral for the loan. Margin loans do not come with an outlined repayment plan, but the account value must be maintained above a particular threshold known as the maintenance margin.
Maintenance margins are set by financial regulators, such as Financial Industry Regulatory Authority (FINRA), the Securities and Exchange Commission (SEC), and the Federal Reserve. Individual brokerages can also set their minimum balance requirements, usually at a higher level than the requirements set by the financial regulators.
Key Margin Requirements
The following are the requirements that investors must fulfill before setting up a margin account:
1. Minimum Margin
The investor is required to deposit a minimum margin in the margin account before they can start trading. FINRA requires a minimum margin of $2000, or 100% deposit equivalent to the 100% purchase price of the securities they want to buy on margin.
2. Initial Margin
Once the investor starts trading, their borrowing is limited to 50% of the stock value they intend to buy. The investment doubles the buyer’s purchasing power. For example, if they place $5,000 in their margin account, they can purchase $10,000 worth of securities.
3. Maintenance Margin
FINRA requires a maintenance margin of 25%, but individual brokerage firms are free to set a different minimum balance for their customers, usually 30% to 40% of the total value of securities in the margin account.
A margin call is issued if the investor’s equity falls below the required minimum margin. A decline in the value of the securities and increased withdrawals are some of the factors that can trigger a margin call.
4. Margin Interest Rates
The margin interest rate is the annual interest rate that an investor owes on a margin account or a margin loan. Margin interest rates differ from one brokerage to another. Interest rates on margin accounts range from 3% to 4%, higher than what is offered in a home equity line of credit (HELOC).
The interest rate may be favorable if the investor is using the margin account to make short-term investments. If they use a margin account extensively, the interest charges may accumulate and reduce the returns.
What is a Margin Call?
If the investor’s margin account value falls below the maintenance margin, a margin call is made by the brokerage firm to warn the client of the declining stock value. The alert requires the investor to either sell part of the securities or deposit more funds into the account.
In a scenario where the investment value falls steeply and quickly, the broker may be compelled to sell the assets without alerting the investor. Generally, margin calls may trigger a forced sale of securities at below-market price values, hence incurring losses in the process.
CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)® certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:
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