How exactly does buying on margin work and why is it controversial?
Buying on margin is an investment strategy that allows investors to leverage cash or securities held within a margin-approved brokerage account for the purpose of purchasing additional investments. Brokerage firms allow an investor to borrow money up to a percentage of the total cash and securities held in the investor's account and secures those holdings as collateral for a margin loan. For example, an investor with $5,000 in cash in a margin account may be allowed to buy up to 50% of the purchase price of marginable investments. This gives the investor the option to purchase up to $10,000 worth of marginable securities within the account, with 50% of the purchase price provided by the investor and the other 50% provided by the brokerage firm as a margin loan. Investors can increase buying power, which can lead to greater upside return on a securities purchase in a margin account.
Brokerage firms that offer margin account charge interest on the margin loan for as long as it remains unpaid. Interest rates range from firm to firm, but are often less than the interest rate charged for personal credit cards or unsecured loans. Each brokerage firm has specific guidelines as to what is considered a marginable security. Typically, securities that sell for a minimum of $5 per share and are traded on major U.S. stock exchanges are allowed to be bought and sold within a margin account.
Although investors can amplify returns within a margin account because of the additional buying power offered, there are risks involved. Buying on margin exposes investors to greater risk than what is experienced when buying securities in a conventional brokerage account. For example, if an investor purchases 100 shares of a stock currently trading at $50 per share in his brokerage account without margin, and the share price drops to $30 per share, the investor has lost $20 per share on the transaction.
If the investor had purchased an additional 100 shares of the same security on margin, his loss on the price drop would be greater. Because the investor must pay back the borrowed funds in addition to the interest charged on the margin loan, his total investment loss is higher than if he did not purchase the additional stock on margin.
In addition to exemplified losses, buying on margin is controversial because of the ebb and flow of the securities market. Marginable investments are used in a margin account as collateral for the borrowed funds provided by the brokerage firm. These investments fluctuate in price each day, but the total amount of the margin loan remains unchanged until it is repaid. It is common that brokerage firms offering margin accounts require a certain percentage of equity or cash to be held in an investor's account in order to meet the minimum loan collateral requirements.
When the securities being used as collateral for the margin loan no longer meet the minimum percentage, a margin call will be issued. This requires the investor to deposit cash or approved securities into the account in order to fulfill the required minimum.