Everything You Need To Know About Margin Accounts
Margin accounts can be an effective tool to leverage the buying power of your investment portfolio. Simply put, margin accounts allow you to borrow funds from a broker to purchase securities, in addition to using your own money. The most common type of investment vehicle purchased with margin accounts are stocks; however, futures and options contracts may also be available, depending on the broker. The securities purchased with the loan are held as collateral by the broker, with the borrower accumulating interest until the loan is paid off, along with any applicable fees and commissions.
For example, let’s say you have approximately $5,000 in your margin account, but want to purchase 100 shares of ABC Corporation, which is currently trading at $100 per share. You require a total of $10,000 to make this purchase (before accounting for any commissions), so you borrow the additional $5,000 from your broker to do so. You now own the 100 shares you wanted, but the 50 you purchased with the loan from your broker are held as collateral. Additionally, you will begin to accumulate interest on the $5,000 you borrowed, until the loan is repaid.
Using a margin account in this manner allows you to increase the amount of money you invest, which enhances your potential profit. At the same time, purchasing securities with borrowed assets magnifies any potential losses; if the securities decrease in value, not only could you lose money on your investment, but you would still owe the broker for the original loan and any interest.
With so many variables and diverse outcomes, understanding the potential risks and rewards of a margin account are key to determining whether this solution is right for you.
Why use a margin account?
While using a margin account as a source of investment capital can significantly increase the potential earnings of your investment, there are additional features that make the solution attractive, particularly to the more sophisticated investor. For one, under Canadian tax law, interest charged from money borrowed for the purposes of earning income is tax deductible. This could be especially appealing to those in a higher tax bracket. Additionally, the greater investing power available to purchase a wider variety of securities makes it an effective diversification tool for any portfolio, and can help to reduce volatility.
Risks of borrowing to invest
Just as the rewards you can reap when investing with borrowed money are higher, losses can be felt more intensely as well. With increased buying power comes increased costs; while you have more capital to invest, you now have to pay back your loan, with interest, even if the value of your investment decreases.
One other risk scenario to keep in mind is a margin call. If the value of the loan within the account falls below a certain amount (known as the maintenance margin), this could result in a margin call by the broker. In this scenario, the broker can request the investor deposit more money into the account, or sell securities to cover the difference. Different brokerages may have different maintenance margin requirements, and brokers have the authority to sell investors’ holdings at their own discretion, adding to the uncertainty of using a margin account.
So, is a margin account right for you?
Only you can answer that question, based on your personal knowledge and comfort levels. Margin accounts can be an ideal solution for more sophisticated investors looking to take advantage of timely market opportunities, and those who can handle more risk and volatility in their portfolio. They may also be a good fit for those who can quickly adapt to changing investment situations, particularly when faced with negative performance or a margin call. If used properly, the benefits and earnings can compound, to provide results the investor may not have been able to achieve on their own.
How you choose to invest for your future is a matter of your available funds, priorities, and comfort level. Consider all your options before deciding what is right for you.