Buying On Margin: Should You Borrow Money To Buy Stocks?

The idea of borrowing money to invest in the stock market can be very appealing for risk-tolerant investors.

Indeed, there are a number of strategies that utilize our ability to borrow money to buy stocks:

  1. When expected returns are lower than they normally are, borrowing money to buy stocks could juice returns to more satisfactory levels
  2. Buying high yield stocks with debt whose interest rate is below the stock’s dividend yield can result in higher overall portfolio income
  3. Similar to #2, buying stocks with expected returns above the cost of debt can boost your total return (not just dividend yield)

On the surface, the return-enhancing capabilities of borrowing money to buy stocks are very appealing. With that said, there are significant risks to buying on margin and borrowing money to borrow stock.

In this article, we discuss the characteristics of margin accounts, the benefits and potential downsides to borrowing money to buy stocks, and three actionable techniques that you can use to invest using a margin account if you so choose.

Characteristics of Margin Accounts

Margin accounts have two important characteristics:

  1. Interest Rate
  2. Maintenance Margin/Leverage Limits

We discuss each characteristic in detail below.

Margin Interest Rate

The interest rate of a margin account is the most straightforward characteristic. It is the rate of interest that investors must pay on money that is borrowed within the account.

For example, if an investor deposits $100,000 into a margin account with a 10% interest rate and buys $140,000 of stocks, they would pay $4,000 in interest each year. This is calculated as the total securities owned ($140,000) minus the account’s equity ($100,000, which gives $40,000) and multiplied against the margin interest rate (10% x $40,000 = $4,000). In general, margin account interest is withdrawn from the account each month by the brokerage account provider (such as Fidelity, TD Ameritrade, or Interactive Brokers).

Maintenance Margin

The second characteristic of margin accounts is more nuanced and is a measurement of how much leverage is permitted within the margin account. There are two ways to express these permitted levels of leverage.

The first is by using a term called “maintenance margin”. Maintenance margin is calculated by dividing the minimum required equity by the total security value. If an account has a maintenance margin of 30%, then $3,000 of account equity must be deposited for every $10,000 of securities purchased.

Leverage Limit

The second way to express permitted leverage is by stating a “leverage limit” – which, importantly, is the inverse of maintenance margin and show the possible dollar amount of securities that can be purchased for every $1 of deposited equity. If a margin account has a leverage limit of 4x, then $4 of securities may be purchased for every $1 of deposited equity.

You might be wondering – what happens if your account value declines and you no longer satisfy these permitted margin requirements?

Margin Calls

For most investors, the risk of investing on margin is the probability of experiencing a “margin call”. A margin call occurs when your account equity falls below some acceptable limit that is predetermined by the brokerage company – the maintenance margin that was discussed previously. Like most loans, margin loans require collateral, and when that collateral declines in value, the brokerage company will force you to sell securities to reduce your leverage.

To understand how this is possible, consider the following example:

  • Margin account leverage limit of 3x (which means that $1,000 of equity allows for the purchase of $3,000 in securities)
  • An investor deposits $100,000 into the account, and purchases $150,000 of securities, giving him a leverage ratio of 1.5x. This is only half of the maximum allowable leverage limit, which ostensibly suggests that the investor has a small probability of experiencing a margin call
  • A statistically improbable stock market correction occurs, leaving asset values declining by 50%. Here’s how his equity, debt, and leverage ratio change as the price of his investments fall:

Margin Call Example

On the surface, it might not be clear why a margin call is a negative occurrence. It has to do with the price of the securities being transacted. Because margin calls are a result of declining securities, they cause you to sell at low prices – which is the opposite of the buy low, sell high mentality that you should be practicing.

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Disclaimer: Sure Dividend is published as an information service. It includes opinions as to buying, selling and holding various stocks and other securities. However, the publishers of Sure ...

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