Some of the pitfalls include bankruptcy risk and double taxes on dividends. An investor or trader who agrees to keep a certain amount of capital may open a margin account with a broker. At some point, you might feel as though you must own a particular stock but lack the funds to do so. It's possible that you could borrow money from your margin account to pay for the purchase. Is using a margin loan to purchase stock recommended? Find out what might occur and what steps you can take to reduce, but not completely eliminate, the significant losses that could happen when using a margin loan.
Main Points
- With a margin loan, you can borrow money from a broker while using your own securities as security.
- You would need to make a full payment right away because these loans can be canceled at any time.
- Sudden price drops can be caused by companies going out of business and market panic, which could prompt your broker to call in your margin loan.
- A bank line of credit can be used as an alternative to a margin loan.
A margin loan is always available to you
Like a bank loan, a margin loan is different. Because it is stated in the margin account agreement, brokers can call in their loans at any time and anticipate receiving payment immediately. They don't care if you have enough non-liquid collateral to back you up in case something happens or if you have good credit. Because they also have financial obligations to fulfill, brokers expect payment to be made immediately if they request it. Important: Paying a margin call is your only option; it comes with the territory of having margin privileges. No matter what, you have to make a payment. An explanation for a margin call is not necessary. A brokerage may decide to reconsider your loan. It might have encountered some financial difficulties and desire to strengthen its balance sheet, or someone might have a bad feeling about the market and desire to be ready. All margin loans might be called in by the brokerage to lower risk for its shareholders.The Real Debt of Purchasing Stocks on Margin
Balances on margin debt are actual debt. They share the same level of reality as going to the bank to sign for a mortgage, using a credit card, or getting a student loan. Investors occasionally fail to treat these liabilities with the respect they deserve because new margin loans can be easily created under normal circumstances. You shouldn't take out a margin loan if you don't have the money to pay it back immediately. You should always have enough cash on hand to pay the entire worst-case scenario balance in full due to the risk of loan recall. Have the money on hand right away, in the bank.Business Failures
Occasionally, businesses experience permanent capital impairment or bankruptcy. Many investors not only invested reckless sums of money in "booming" companies in the hopes of becoming wealthy, but they occasionally also bought common stock on margin and piled up call options to do so. As an illustration, let's say you took out a $10,000 margin loan and bought common stocks from a tech company that has been doing well for the last two years because you believed it was about to explode. You decided to invest $5,000 in call options, but you didn't have enough, so you also borrowed from your margin account. Warning: The losses will start to add up quickly if a company whose stock you bought on margin goes bankrupt. The business is discovered fabricating its financial data two weeks after you make your purchase. Your $10,000 investment becomes worthless due to a significant stock sell-off, and your broker decides to call in your margin loan. You must pay $15,000 right away. You will need to take out a loan to pay back your broker because you don't have any money set aside to make a payment. Your bank charges you a 10.5 percent interest rate for a 48-month loan because you have no collateral to pledge as security for the loan. You'll end up paying close to $18,500 in interest if you make all of your payments on time.Market anxiety
Market panics, shifts in the market, volatility, and shocks will always occur. Because many investors lack a disciplined approach to investing, they end up following the herd and suffer sizable losses when the market indicates a potential downturn. Investors start to panic and sell when the markets start to fall in order to limit their losses. Market panic results as predictions come true and the market keeps falling. If a margin call occurs, even though you may not be trembling like the rest of the investing herd, it may deplete your cash reserves or push you into debt if you haven't planned for it.No Way to Sell or Capture Prices in the Mid-Drop
It's a common misconception among novice investors that stock had to stop between $99 and $21 multiple times to fall from $100 per share to $20 per share. Sadly, prices may move from Point A to Point E without reaching Points B, C, or D. Even worse, if prices drop to new lows, the stock market may completely shut down, making it impossible for you to sell any of your holdings to satisfy a margin call. You will be needed to pay the full amount by wire transfer or by assuming an immediate bank loan to the broker.Higher Taxes Could Result From Dividend Income
Consider borrowing $100,000 to purchase shares of Royal Dutch Shell. If the shares return 6.5 percent, your annual dividend income should be around $6,500. If you had purchased the stock outright, those dividends would have been considered "qualified dividends," meaning you would have had to pay much lower capital gains tax rates, which are typically between 0% and 20%. Instead, there's a decent chance that your broker will take the stock you borrowed against your account and lend it to short-sellers. You won't even be aware that it occurred or that it ever happened. The broker will keep the extra money for themselves. Important: It's possible that the stocks will not even pay you a dividend or payment. Brokers may retain them in order to cover your margin. Even though it appears that you do in the brokerage account, you don't technically own the stock when the dividend is paid on it. A "payment in lieu of dividends" in the amount of the dividends you would have otherwise received may be given in its place. Your ordinary income tax rate, which may be nearly twice as high, is applied to payments made in place of dividends. You would receive your $6,500 and be required to include it in your yearly income. Instead of giving you an extra $6,500 to reinvest, it might be enough to push you into the next tax bracket and raise your taxes.Can You Use Debt for Brokerage Margin?
A good rule of thumb for margin balances is never to exceed 5% of the market value of a loan, and even then, only use it for urgent cash flow needs, such as when you need to make a purchase right away but need to deposit more money soon. An agreed-upon line of credit (LOC) with your neighborhood bank might be a preferable alternative. With a line of credit, you can borrow money at any time and repay it over time rather than using all your available funds. Another choice is to keep your stocks and other holdings in the non-margin account and separate your U.S. Treasury bill holdings into your margin-authorized account. Then, you could withdraw as much as 30% of your Treasury reserves' market value. Although there is still some risk of loss, it is significantly lower than what could occur with a margin loan.Most Commonly Asked Questions (FAQs)
What is the price of trading on margin?
As with most loans, interest fees are used to offset the marginal cost. Depending on the brokerage and the loan's size, you'll pay a certain interest rate. Interest rates decline as the debit size grows. TD Ameritrade, for instance, assesses an effective interest rate of 9.5 percent on debit balances under $10,000 and 7.5 percent on debit balances over $250,000, respectively. These rates will change in accordance with the general interest rate environment.Which interest on margin do you pay?
However, they are typically billed daily. Margin interest costs are expressed as an annual percentage. But until you pay off your margin debt, you don't have to pay this fee. The brokerage may change this timeline, as was already mentioned. You might be able to pay off a margin debt over the course of several months, or the brokerage may quickly call in its loan. The amount of the debt and how successfully the margin trade performs are the usual determining factors.