09 Jul Margin: Pros and Cons
Depending on your view of risk, margin can either be the greatest tool in the world or something to be avoided at all costs. To understand margin better, let’s begin with the basics.
In finance, buying on margin is borrowing from the brokerage firm (such as Charles Schwab) and using the securities in the account as collateral. Interest is charged on the borrowed amount and compounded daily. Typically margin interest rates are higher than those found in the general market for secured debt (such as mortgage rates or car loans) but lower than those charged for borrowing on unsecured debt like credit cards. Somewhat surprisingly, the interest rates often decline the more money is borrowed. For example, for debit balances less than $25,000 the current margin rate (as of June 2021) at Schwab and Fidelity is 8.325%, but this declines to 6.575% for amounts between $250,000 and $499,999. Interest rates can change at the discretion of the lender.
The amount that can be borrowed is set by the brokerage firm and is dependent on the securities held in the account and is typically limited to 50% of the value of the marginable securities. Most stocks, mutual funds and ETF’s can be margined if they are priced above $3/share. Penny stocks, restricted stocks, annuities, and options are not eligible for margin. Similarly, most investment-grade corporate, Treasury, municipal, and government agency bonds can be margined, but non-investment-grade municipal and corporate debt cannot.
Not all types of accounts can be margined. The broad category of taxable accounts (for example individual, Joint Tenant, Tenants in Common) are eligible for margin while retirement accounts (IRAs, 401(k), QRP) are not. The brokerage requires written consent by the account holder to allow margin on each account. This can be part of the initial account application or added later if desired. Accounts must generally have a minimum balance of $2000 in cash or eligible securities to begin borrowing, but this varies from firm to firm.
Why use margin?
Margin is convenient and easy to use. There are no set-up fees to establish this line of credit and there is no pre-defined repayment schedule. The rates are potentially more cost-effective than other options, particularly when used for short-term cash needs. Margin can be used to cover unexpected bills, avoid bounced checks, and fund a bridge loan. When margin is used in lieu of selling securities to raise additional cash, it can help the investor defer capital gains taxes and keep the portfolio fully invested. Under these circumstances, margin can provide a valuable tool with minimal risk.
Investing with margin is a different animal. Using margin to purchase additional securities in an account can lead to greater returns and that is its appeal to investors. For example, let’s say that you have $25,000 in marginable stock in your account. By using margin, you could purchase an additional $25,000 worth of stock ($50,000 total) using your existing securities as collateral and no cash outlay. If the value of the stock increases, your profits are magnified. For example, a 30% increase on $25,000 is $7500 whereas a 30% increase on $50,000 is $15,000. Even reducing this by the margin cost, it is still a very hefty increase in profit.
What is the downside?
Leveraging your account through margin dramatically increases the downside risk. If the securities (that you have used as collateral) lose value, you must still repay the amount borrowed. Furthermore, the interest still accrues on the borrowed amount, regardless of the value of the securities purchased. Let’s look at the scenario above where we purchased $50,000 worth of stock by margining a $25,000 account. Assume that the share price declines by 40% and the stock is sold for $30,000. The margin loan of $25,000 plus the interest would still need to be repaid, leaving you with less than $5000 of your initial $25,000 investment- an 80% loss! In this worst-case scenario, you would receive a margin call from the brokerage requiring you to deposit additional cash; failure to meet this margin call could force the brokerage to sell securities in the account to protect their interest. It is typical currently to see a “maintenance margin” of 30% – that is the minimum equity that the investor must have to avoid a margin call.
We have seen cautionary tales about margin before. The Great Depression was a prime example of the excessive use of margin. In the 1920s people could margin up to 90% of the value of their securities (effectively buying with just 10% down). When stock prices began to fall, these investors received margin calls. However, on Black Tuesday (October 29, 1929) there were no buyers to be had for the securities, stock prices collapsed, and the investors could not repay their margin loans. Although stricter margin requirements are now in place, it is wise to remember that margin is a sharp and potentially dangerous tool and should be used very carefully.