The concept of margin accounts is one that often comes up in the business press. Since bad news makes headlines, they are often mentioned when someone ends up losing money. This, however, doesn’t mean that it is always a bad idea to use them or that losses are inevitable. It just means that publications skew perceptions. Here is an honest overview of margin accounts and how they work.
What Is a Margin Account?
A margin account is dedicated to providing funds to buy stocks. In a nutshell, account holders borrow funds from their brokers. The stock they already own serves as collateral. Typically, the margin account will allow the borrower to obtain more funds than the collateral is worth. For example, someone with $5,000 worth of stock in the account may be able to borrow $5,000 to invest in other stocks.
Because of how margin accounts work, risk is an inherent property. On the upside, they allow investors to buy into stock that they could not otherwise afford. This makes it possible to reap big benefits since the investors can purchase rising stock when a good opportunity appears. The downside is that stocks can fall before the investor has a chance to resell them. Then, the loss is compounded by the need to repay the broker.
How Much Can I Borrow on Margin?
As with other loans, multiple factors go into determining the borrowing limit. The amount of collateral is important – someone who has a brokerage account with $1 million in stock will almost always be able to borrow more than someone whose entire account is worth $2,000. Credit rating and other indicators of stability also matter.
How Are Margin Rates Calculated?
Each brokerage has its own formula for calculating the interest rates on margin accounts. There is, however, a general formula that will give a rough idea of how much interest that will need to be paid. For this, divide the brokerage’s interest rate by 360 in order to arrive at the daily interest rate. Then, multiply the result by the amount borrowed and by the number of days it will remain unpaid. By doing this, investors can determine how much interest they’ll actually have to pay and thereby be able to factor this into their calculations.
When calculating the potential end results of a margin trade, it’s important to run the numbers on losing scenarios as well as winning ones and understand that the use of margin means that you can lose more money than you have deposited in your account. This due diligence helps ensure that the investor will be financially ready for any eventuality.