Margin accounts explained: Are the rewards worth the risks?

Aside from traditional cash accounts, many brokerages also offer margin accounts. These allow you to borrow against the value of the assets in your portfolio, giving you more money to invest. While this might sound like a win-win, investors should know that a potentially greater payoff may also mean taking on greater risks. 

Key terms 

• Minimum margin: The minimum amount investors are required to deposit into their account to begin trading trading on margin. 
• Initial margin: The percentage of equity a margin account holder must contribute in cash to the purchase of securities.
• Maintenance margin: The total amount of capital that must remain in an investment account to hold an investment or trading position and avoid a margin call. 
• Margin call: When the value of your brokerage account falls below the margin requirement, a margin call requires the you to deposit more money into the account or sell off assets to maintain the account value. 
• Broker call rate: The rate that investment firms pay to borrow the money used to fund margin loans. 

What are margin accounts? 

A margin account is a type of brokerage account where the broker-dealer lends the investor cash to purchase securities (or use the funds for other short-term needs). This is known as a margin loan.

The catch: Your portfolio serves as the collateral, and you pay interest on the amount borrowed. The interest rate depends on the brokerage, but in general, margin loan rates tend to be lower than interest rates for credit cards and personal loans. There’s also no set repayment timeline, meaning you can pay back the loan at your convenience (within reason).

Under Federal Reserve Board Regulation T, investors are allowed to borrow up to 50% of the purchase price of new marginable investments. The exact amount can vary depending on the particular security, however.

Here’s how it works: Say you have $10,000 in cash sitting in your brokerage account. You borrow another $10,000 from your brokerage to buy $20,000 worth of stock shares. Over the year, the value of those shares increases by 40%, and the value of your investment grows from $20,000 to $28,000. Now the equity in your account (the value of your securities minus the amount borrowed from your brokerage firm) has grown from $10,000 to $18,000—an 80% increase.

Keep in mind that there may be certain rules or limitations in place that impact how much you can borrow and how much you’re expected to keep in your account. “If the value of the securities drop below [a certain] threshold, the brokerage firm will require investors to increase the value of the account by depositing funds or selling securities,” says Brian Walsh, a certified financial planner and manager of financial planning at SoFi. 

Each brokerage also has its own rules about which securities are marginable. Usually, they include most securities listed on the New York Stock Exchange (NYSE) and NASDAQ that trade for at least $5 per share, as well as mutual funds owned over 30 days, approved OTC stocks, and certain bonds. Securities in your retirement accounts, such as a 401(k) or IRA, are not eligible. Some high-risk investments may not be marginable, either.

The biggest pros and cons of margin accounts

The benefit of a margin account is pretty clear: It increases your buying power, allowing you to acquire more shares than you could have otherwise with cash alone. For investors with little capital to start, this could be a tempting proposition and an easy way to diversify your portfolio while generating greater returns over time. Margin accounts can also serve as a flexible, secured line of credit for non-investment purchases.

However, margin accounts are not without risk. Trading on margin could result in: 

• Margin calls: A margin call is essentially when a brokerage notifies an investor that the value of their account has fallen below the brokerage’s maintenance margin. When this happens, it’s up to the investor to add more cash to their account or sell off securities to cover the gap—usually within a short time frame. “If you cannot cover the margin call with cash or transferring un-margined securities, then the brokerage firm will sell shares,” says Walsh. “That means realizing a loss, since a margin call would come into play when the value drops.”
• Bigger losses: Just as buying investments on margin can boost your overall returns when the market is going up, it can also amplify your losses if those investments lose value. Let’s take our previous example: Say that instead of earning a 40% return, your $20,000 investment actually drops by 50% to $10,000. But you still owe the brokerage $10,000 for the margin loan. That equates to a 100% loss, plus interest and commissions.

How to know if a margin account is right for you 

Margin accounts come with major risks, so it’s important to take a close look at your financial situation and long-term investment strategy to determine if it makes sense for you. While brokerages will have their own eligibility requirements, Walsh says that you should consider the following to help you weigh whether or not it’s smart to open a margin account:

1. Do you have an emergency fund? If not, you might consider putting extra cash in a high-yield savings account and building a financial cushion for yourself before you put that money in the market. 
2. Are you free of high-interest debt? Carrying debt balances with high interest rates can cost you tons and wipe out any returns you gain elsewhere. Prioritize eliminating that debt before you direct extra funds to your brokerage account. 
3. Are you saving enough for retirement? Be sure your retirement needs are being met before you attempt to play the stock market. Remember: Margin trading isn’t allowed in retirement accounts, so aim to max out your tax-advantaged 401(k) or IRA before putting money in a margin account.  

If you can check all those boxes, Walsh says you may consider investing on margin—as long as you limit exposure to speculation and reduce the risks of margin calls. “Generally, no more than 5% to 10% of an individual’s entire investment portfolio should be invested in speculative investments such as margin, cryptocurrency, derivatives, or land,” Walsh says. “They should also limit margin exposure to an amount low enough to avoid the risk of a margin call, unless they have cash on hand to cover the call.”