Borrowing money to invest: Learn the basics of leverage, margin loans, and margin calls.
Margin trading increases your buying power by allowing you to borrow money to invest. While it can boost potential gains, it comes with added risk that may also lead to greater losses. Before using margin, make sure you do your research and understand how it works.
What is margin?
Buying on margin involves taking out a loan to purchase investments, with other securities in your brokerage account used as collateral. The main benefit of margin is leverage—you can buy a larger investment than you’d be able to otherwise, which in turn gives it more opportunity to grow.
For example, let’s say you want to invest $20,000 in a stock or fund but only have $10,000 available. You can borrow $10,000 on margin to purchase the full $20,000 worth. Your gains and losses are then based on a $20,000 position instead of just $10,000.
But remember, you still have to pay back the $10,000 loan with interest.
How margin can amplify gains
When investments rise in value, margin can increase your returns. So from the example above, if the stock rises by 10% your $20,000 position grows to $22,000. After repaying the $10,000 loan, you’d have $12,000 (before interest and fees), a 20% gain on your original $10,000 and a $2,000 profit instead of $1,000.
In this scenario, you’ve generated extra income for yourself by buying on margin.
How margin can amplify losses
Leverage works both ways. When an investment declines, losses are magnified in the same way gains are. If the stock falls by 10%, your $20,000 position drops to $18,000. Once you pay back the loan you’ve only got $8,000 left, a 20% loss (again before interest and fees).
Now imagine the stock dips 50%. Your $20,000 becomes $10,000 and when you repay the loan you have nothing left. Your investment is completely gone and you end up owing money to cover the interest—you’ve lost more than you even invested in the first place.
Understanding margin calls
Brokerages require you to maintain a minimum amount of equity in your account, often around 30%. If your equity percentage falls below this number you receive a margin call, meaning you need to deposit additional cash or add more eligible securities to your account.
If you don't satisfy the margin call promptly, the brokerage may sell some or all of your investments to cover the loan.
Margin call example
The loan - You invest $10,000 and borrow $10,000 to buy $20,000 of stock (typically 50% of the purchase price is required to be your own money), with a brokerage that requires a 30% maintenance margin:
$10,000 (your equity) + 10,000 (loan balance) = $20,000 (investment value)
Stock value drops - The investment declines in value from $20,000 to $14,000. Your equity (what you own after subtracting the loan balance) is now only $4,000:
$14,000 (investment value) − $10,000 (loan balance) = $4,000 (your equity)
Equity percentage - The amount of the total investment that you own has slipped from 50% down to 28.6%:
$4,000 (your equity) ÷ $14,000 (investment value) = 28.6% (equity percentage)
Margin call - Since 28.6% is below the required 30%, a margin call is triggered. To bring your account back into compliance you could:
- Deposit more cash
- Add eligible securities
- Sell investments and reduce the loan balance
Otherwise the brokerage can sell securities in your account without consulting you, potentially locking in losses.
Margin interest
As with any loan, interest charges apply. Margin interest typically accrues daily and accumulates for as long as you have an outstanding balance, reducing your overall return (even when the investment performs well). The longer it takes you to pay off the loan, the more interest you owe. For this reason, margin loans are more commonly used for short-term investments.
Make sure you understand the interest rate and how it works prior to borrowing on margin.
Is margin trading right for me?
For some investors, margin may provide additional flexibility and greater purchasing power. It’s also a key component of many advanced trading and options strategies. However, borrowing money to invest increases risk and can lead to substantial losses if markets move against you.
Before using margin, take time to understand how margin loans, leverage, interest charges, and margin calls work. Consider your financial situation, investing experience, goals, and risk tolerance when deciding if margin trading may be right for you.
