Margin Loans: How It Works and Is It Right for You?
You’ve heard it said that higher risk could yield a higher reward, and margin loans are no exception. A margin loan can increase profit, but it also comes with many drawbacks. Even the pros can get it wrong!
Still, a margin loan from your broker isn’t always a bad idea. Many investors have margin debt — the Financial Industry Regulation Authority (FINRA) reports an aggregate margin debt balance of $861 billion as of May 2021.
But it isn’t right for everyone. Our focus is going to be using margin loans in opportunistic uses as part of your financial plan. Here’s what you need to know before taking the plunge into a margin loan.
What is a margin loan?
A margin loan is a type of secured loan where your brokerage firm uses your investments as collateral. If you don’t make the payments, your broker can seize your investment assets to repay the balance.
It’s similar to how a bank can lend you money using the equity in your house to secure the loan. But instead of a home, a brokerage firm can lend against the value of a portfolio’s stocks, bonds, and mutual funds.
How does a margin loan work?
Margins aren’t one-size-fits-all. Each broker can offer loans under their own terms. Generally, brokers will have a list of investments they consider “marginable” that can be used as security for a loan.
Using the value in your portfolio, you can take out a margin loan for investment and non-investment needs such as:
● Stocks and bonds
● Real estate
● Home renovations
● Wedding
● Medical procedure
● Another large or unforeseen expense
So, can you use a margin loan to buy a house? Yes — and it can make sense if you bought a new home that closes before the old one, leaving you short on cash.
But remember: The more you borrow, the more risk you take on. Just like a margin can increase your borrowing power and magnify your potential profit, it can bury you in a mountain of debt very quickly.
Margin interest
Like most loans, you’ll pay interest — called margin interest — on the amount you borrow. Your broker can charge margin loan rates based on the value of your loan. For example, Fidelity’s margin loan interest as of July 2021 ranges from 4% to over 8%, depending on your debt balance.
Margin call
Because a margin uses your portfolio to secure the loan, margin loan accounts have minimums you must keep. The requirements can vary by broker, but the value of cash and investments must stay above the level set by the firm.
If the value of your portfolio falls, you might receive a margin call. A margin call is when a broker requires additional money or securities to bring the margin account up to the minimum required level. If you don’t, the brokerage can liquidate your securities to meet the margin call.
How much can you borrow on margin?
You can borrow to leverage your portfolio and purchase marginable investments, but this use of margin loans is discouraged — it’s risky behavior that can hurt your finances in a hurry.
Instead, think of margin as an opportunistic way to borrow. You might use it as a short-term debt vehicle. For example, let’s say you’re buying a new house and need a temporary loan to get you through until your old home closes.
How much can you borrow on margin? It varies by broker, but you can generally borrow up to 50% of the value of your portfolio. Let’s say you need $250,000 to close on your new house, so you check your Schwab brokerage account. Luckily, you have a $500,000 stock portfolio and can access the money you need.
In this case, your margin loan acts as a bridge loan. You’re able to close on your new house and pay off the margin once you get the proceeds from the sale of your old home.
The benefits of margin
Margin loan accounts have several advantages. We generally do not recommend margins loans as a means to speculate on investments. It can become a financial weapon of wealth distribution. Generally, the benefits of a margin loan are:
● Competitive interest rates that are typically lower than a credit card or personal loan
● Margin loan tax benefits when you deduct investment interest expenses
● Getting access to funds quickly because your investments are used as collateral
● Supplementing cash flow if you need money for a home repair, wedding, medical procedure, or another large or unforeseen expense
● Opposed to selling investment for short term capital gains you could use a margin loan to fund a near term need and sell your investment once it reaches long term capital gains status
● If you have recognized a lot of capital gains in one tax year or would like to spread capital gains over several multiple years a margin loan may offer a short term solution
The risks of margin
You add a certain amount of risk anytime you take on debt. Margin accounts are especially risky. The stock market can fluctuate, causing the value of your portfolio to change from day to day. If your margin account drops below the required minimum, you may have to meet a margin call quickly.
Many risks go along with margin loans, including:
● Losing more funds than you deposited into the margin account
● Not having a right to extend the time to meet a margin call
● The forced sale of your securities without contacting you to cover a margin call
Managing your margin debt
You can reduce your risk by borrowing less. Instead of borrowing the full 50%, consider borrowing 20% to 30% or less. It can help you manage potential losses and reduce the chances of a margin call.
You could also not borrow at all — selling less attractive investments can help you fund more attractive options to potentially increase the value of your portfolio.
However, margin loans can be a valuable tool in some situations when managed wisely. If you’re thinking about using a margin loan account, a financial planner can review your options to help you decide if it’s right for you.
Brandy Branstetter, CFP(R)