What is a Margin Loan?
A margin loan or a margin account is a loan from a broker house to a customer that allows the customer to buy shares on credit.
The term margin itself refers to the difference between the market value of the purchased shares and borrowed amounts from brokerage. Interest on the margin loan is usually calculated on the outstanding balance on a daily basis and is held over margin account. As time goes by, the outstanding debt goes up and interest expenses accumulate. The brokerage also holds securities as collateral for the loan.
A simple example of a margin purchase can be an investor buying shares with a market value of $ 10,000 but only with $ 5,000 of their own money. The other $ 5,000 would be provided by the brokerage as a margin loan.
It sounds simple, but margin loans are not simple.
If you want to trade on margin, the first thing you need to do is open a margin account. By law, this requires an initial investment of at least $ 2,000. But this amount could be more, depending on the brokerage’s own rules to open the account. This created amount is called the smallest margin. When your account is open, you can borrow up to 50% of the price of the securities you want to buy. Understand, you do not need to borrow the full 50%
The amount you borrow can be less than 50%. The 50% payout is called your initial margin. As long as stock prices remain stable or go up and you make your interest payments your life will roll smoothly.
But you need to be aware of what is known as the maintenance margin if stock prices fall. According to the rules of the New York Stock Exchange (NYSE) anyone who buys shares by margin must maintain a minimum of 25% of the total market value of the securities in the margin account. Some brokerages require an even higher percentage.
Falling stock prices could take your account below the minimum and brokerage fees the house will require you to put more cash or securities to bring your bet to the smallest. The call from brokerage requires these extra funds known as a margin call. Depending on the terms of the marginal loan agreement you originally entered into with brokerage, even though they may have legal right to sell securities out of your account without consulting you, getting back to maintaining the minimum.
Undoubtedly, margin accounts allow an investor to gain control of a large block of stock at a minimal investment. Sophisticated investors will use a margin loan to increase their personal wealth by using the influence of borrowing money.
However, if stock prices go the wrong way, the investor with the margin loan is not only responsible for the borrowed but also maintaining their margin account minimum. Now the lever works the other way and the falling stock prices combined with the unprecedented margin loan can cause an investor significant financial problems.