The Pluses and Minuses of Margin Loans
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If you own a portfolio of stocks in a taxable brokerage account (not an IRA, Roth IRA, 401(k), or other tax deferred account), then you’ve got access to cash when you need it in the form of a margin loan.
Four Advantages of Margin Loans
First, they’re relatively simple. No proof of income, tax returns, deed, proof of title insurance, or nosy bank officer asking where certain deposits came from or went.
Second, because of the above, margin loans are surprisingly fast. All they require is a call to your broker and, with some brokerages, you’re able to make a withdrawal online.
Third, there’s no set amortization or payback period. You’ll be charged interest each month, but in terms of the principle, you can pay it back whenever it’s convenient to you.
Finally, because margin loans are not underwritten in the conventional sense of the word, and are relatively risk-free for the brokerage, they tend to be cheaper than conventional bank loans. Basically, the more you borrow, the lower the rate.
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How to Protect Yourself from a “Margin Call”
The big drawback to margin loans is the possibility that the underlying securities collateralizing the loan fall below a certain level, resulting in a so-called “margin call” to put more cash in the account. If you don’t have the cash, the brokerage firm will sell some of your securities to get you back to what they call a maintenance level, which is often 30%.
Here’s an example: Suppose you have $10,000 in a brokerage account and borrow $5,000 on margin. Further, if the $10,000 in securities falls in value to $6,000, your equity in your brokerage account is now $1,000 ($6,000 in securities – $5,000 in margin debt). If your broker’s maintenance requirement is 30%, you need to have $1,800 in equity (30% of $6,000). Since your equity is just $1,000, you will receive a margin call to put another $800 of cash into the account.
If you don’t have the cash, the brokerage firm will sell some of the securities in the account to bring the maintenance requirement up to the proper level. This will be more expensive than it first appears, because the sale of securities will provoke a capital gains tax or a loss.
The way to protect yourself against this eventuality is to borrow small amounts, say 15%, of the value of your account. If you had $100,000 in a brokerage account and borrowed $15,000, the required equity would be $25,500 with a 30% maintenance requirement. In this scenario, the value of your account would have to fall by 75% before you received a margin call.
During the Great Recession, the Dow lost around 50%.* It isn’t pleasant conjecture to think that it might happen again, but if it did, and you kept your margin borrowings to a minimum, at least you wouldn’t suffer a margin call. In fact, you might even have some borrowing capacity left, and if things really go south, you might need the money.
*Amadeo, KImberly, (2019). Stock Market Crash of 2008. The Balance. Retrieved January, 2020