Some brokerage accounts allow investors to borrow money to purchase securities. This practice, known as margin investing, can increase the size of an investment position, but it also increases financial risk.
Margin is a loan secured by securities and cash in the brokerage account. The investor pays interest on the borrowed amount and remains responsible for the debt even if the investments decline.
How margin works
Imagine an investor has $10,000 and borrows another $10,000 from a brokerage firm. The investor can now purchase $20,000 worth of securities.
If the securities rise in value, the investor's gains may be larger than they would have been using only personal cash. But if the investments fall, losses are also magnified. Interest charges further reduce the investment's net return.
What is a margin call?
Brokerage firms require customers to maintain a minimum level of equity in margin accounts. If the account falls below the firm's maintenance requirement, the firm may demand additional funds or securities.
If the investor cannot meet the requirement, the brokerage may sell securities in the account to reduce the shortfall. Depending on the account agreement and applicable rules, the firm may be able to sell holdings without first consulting the investor.
This can force a sale at an unfavorable time and may create additional losses.
Check the account type
Investors should pay close attention when opening a brokerage account. Some applications may present a margin account as a default option. A cash account generally requires the investor to pay the full purchase price and does not allow borrowing from the broker to finance the transaction.
The distinction matters because margin introduces borrowing costs and additional risks.
Questions to ask the brokerage
Before using margin, investors should understand the interest rate, maintenance requirements, circumstances that trigger liquidation, and whether the firm can change its requirements. They should also review the margin agreement.
Bottom line: Borrowing can increase market exposure, but it can also turn a market decline into a debt problem. Investors should understand the loan terms and the possibility of forced sales before using margin.
This article is for educational purposes and is not individualized financial advice.
