Margin account: A brokerage account that allows investors to borrow money to buy securities

• A margin account is a type of brokerage account that allows you to borrow against the assets in your account.
• Borrowing the assets in your account is known as a margin loan and may have a lower interest rate than unsecured loans.
• If the equity in your margin account drops too low, the brokerage could sell your investments without warning.

When you open a brokerage account, you might have the option to open a cash account or margin account. Both types of accounts let you buy and sell stocks and other investments. But margin accounts also let you borrow money against the assets in your account.

These loans can be tempting, particularly when they offer a low interest rate and don't require a credit check. However, you want to understand all the risks you may take on if you accept a margin loan.

How do margin accounts work?

A margin account is a brokerage account that gives you the option to use your account as collateral to borrow money.

"Think of it as an investment account with a line of credit attached to it," says Brent Weiss, a Certified Financial Planner and co-founder of Facet Wealth. "Similar to how a home can have a home equity line of credit."

You may be set up with a margin account by default, or switch from a cash account to a margin account if you've at least met the margin account's minimum balance requirement.

Once you set up a margin account, your account's balance may determine how much you can borrow. However, some investments, such as stocks that trade over-the-counter (OTC) rather than on an exchange, might not be marginable - meaning you can't borrow against them.

"As long as you have sufficient taxable investments, margin loans can provide an easy way to access cash at low interest rates," says Weiss. "Some investors want to increase their purchasing power and even speculate on certain investments, and a margin loan is a simple way to do this, but they need to be aware of the added risk associated with such a decision."

How much do margin loans cost?

Margin account loans are a little different from a loan or line of credit from other lenders. And, in some situations, it might be much easier and less expensive than other loan options.

"It is free to set up a margin loan, which is not the case when you take out a mortgage, where you have loan fees, sometimes have to pay points, and often have to pay for an appraisal of the house," says Erin Scannell, a private wealth advisor with Ameriprise Financial. "None of these costs exist with a margin loan."

Margin loans also generally don't require a credit check or upfront fees, and they may have lower interest rates than credit cards or unsecured personal loans. However, the rates are often variable - based on a broker's base rate, plus a margin rate that depends on your outstanding balance.

There also isn't a set repayment period with margin loans, and some borrowers will wait to pay off the loan until they sell the assets that they bought using the money. However, interest will continue to accrue while the loan is outstanding.

What are the pros and cons of a margin account?

Pros

• Easy to qualify. Loan limits may be determined by the balance of your marginable assets rather than your creditworthiness.

• Fast funding. There won't be a big application process once your margin account is open. "If an emergency arises, you can often get money within 72 hours," says Scannell.
• Low rates compared to unsecured loans. Because they're secured loans, you may receive a lower interest rate than you would with other common types of credit accounts.

• Increase potential returns. Buying investments with borrowed money can increase your overall returns.

• Avoid having to sell when markets are down. Long-term investors whose investments aren't performing well, but who need cash, might not want to sell while markets are down.

• Postpone taxable events. "Borrowing against your investments can help you avoid selling an asset and creating a taxable event," points out Weiss. If you sold your investments for a gain, you may have to pay capital gains taxes on your profits.

Cons

• Increased risk. There's a risk you won't be able to repay the loan, especially if your investments (or the investments you buy with the loan) drop. You could even wind up losing more than you originally invested.

• You may be forced to sell your investments. "If the loan balance exceeds a certain threshold, the custodian can either force an account owner to deposit more funds or sell their investments to cover the loan," warns Weiss. If this happens, you might not have a say in when or which investments are sold.

• Interest accrues and rates may change. Interest will continue to accrue on your loan while it's outstanding and the rate may change at any time.

• The debt could be sent to collections. If your assets can't cover your debt and you don't repay the loan, it could be sent to collections (which could hurt your credit). You might even be sued and have your wages or bank account garnished.

What is a margin call?

Margin accounts have a "maintenance requirement," which is how much equity you need to have in your margin account. At a minimum, you may need at least 50% equity when you take out a margin loan and an ongoing 25% equity based on your account's current value. Although some brokers' "house rules" may require a higher maintenance level.

"If the loan balance exceeds this limit due to borrowing too much or the investments performing poorly, the custodian can require that the account owner provide additional funds to cover the shortfall - also called a margin call," explains Weiss.

There are different types of margin calls, but as a simple example, say you have an margin account with $10,000 invested in securities and take out a margin loan for $5,000.

If your account's total value drops to $7,500, you have only 25% equity ($7,500 minus the $5,000 loan is $2,500). There could be a margin call if the account drops lower.

Quick tip: The same maintenance and margin call rules can apply regardless of how you use the loan. Even if you don't invest the money, you could be subject to a margin call if the assets you're using as collateral drop in value.

"At this point, the account owner can either deposit cash to the account or sell an investment to pay down the loan," says Weiss. "If the margin call is not satisfied in a timely manner, the custodian can force a sale in the account without notifying the account owner."

An example of investing on margin

Investors who use margin loans often reinvest the funds. By doing so, they can use leverage (i.e., debt) to increase their potential earnings. But they're also taking on more risk.

"It always seems like a good idea when markets are going up," says Weiss. "But this can change quickly, and margin loans introduce a lot of risk, amplify losses very quickly, and create a very undesirable financial outcome."

Let's see an example of how the returns can change when you buy 100 shares of a stock that's trading at $100 - a $10,000 investment - with your own money. Then we'll compare it to making the same investment, plus buying additional shares with a margin loan.

Margin accounts vs. cash accounts

Cash accounts and margin accounts are two types of brokerage accounts, and you can use either one to trade securities. Even if you have a margin account, you don't need to take out a margin loan.

The financial takeaway

Margin accounts let you use the money in your brokerage accounts as collateral for a line of credit. It can be relatively easy and quick to take out a margin loan, and the loan may have a lower interest rate than popular unsecured credit accounts.

However, using margin loans to invest can heighten your returns and losses. And you'll be at the whim of the market and your brokerage. If your account's value drops, you may only have a few days to add cash to your account or pay down part of your margin loan. Otherwise, the brokerage may sell your investments - potentially at a less-than-ideal time.

"When used as part of an overall plan, they can be useful tools, but they should always be considered as just one facet of a much bigger financial picture," says Weiss. "Exercise a great deal of caution if you are considering using a margin loan to purchase additional investments."

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