How Margin Loans Work

Margin loans use securities as collateral.
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Margin loans are loans taken to finance the purchase of securities, usually the purchase of stock (also known as equity). The loans are normally extended by the same financial services firm, such a stock brokerage, that the customer uses to trade. They are a common method of financing used by investors and extended by brokerage firms, giving individuals extended credit and increased risk. 

How Margin Loans are Created

The maximum value of a margin loan relative to the value of the underlying securities is set by the Federal Reserve Board. Each firm is free to implement more stringent lending policies than prescribed by the Fed.

The portion of the trade price not financed by the margin loan can be paid for in cash or by posting yet other securities as collateral. If securities are posted as collateral, their value must normally be at least twice the amount of cash otherwise required.

The standard paperwork for opening a margin account typically includes language in which the client allows the firm to lend the securities held therein, at its discretion and with no compensation to the client. More than almost any other type of account, margin account paperwork should be read over carefully, ideally with a financial professional or lawyer to assist with any confusing language.

Upside Potential

Utilizing leverage by buying securities on margin can significantly increase an investor’s potential for gain. For example, paying $10,000 in cash for a security that doubles in value to $20,000 yields a 100 percent gain, exclusive of commissions, fees, and taxes. Buying the same security with 50 percent down in cash ($5,000) and 50 percent obtained through a margin loan ($5,000) would yield a 200 percent net gain (after paying off the $5,000 margin loan), exclusive of commissions, fees, taxes and interest on the loan.

Effectively, the brokerage is letting you use their funds to place trades beyond what your net worth would normally allow. Since you are leveraging larger amounts, the potential for larger gain is also there.

Downside Risk

Leverage cuts both ways. If the value of the security in our example fell from $10,000 to $5,000, a cash customer would incur a 50 percent loss. However, a client who bought the security on 50 percent margin would suffer a complete 100 percent loss. All $5,000 of the remaining value of the security would have to go to paying off the margin loan, and the $5,000 put down in cash would be lost entirely.

A "margin call," which is the last call you want to receive as an investor, results when there is a fall in the price of securities, either the securities purchased with the margin loan, or the securities posted as collateral for it. A margin call requires the borrower to post yet more collateral in the form of cash or securities. The rules surrounding margin can get rather complex, and differ at the discretion of the lender, but some investors go bankrupt not because they made a bad initial investment, but because they did so on margin.

Vetting Clients

Because of the risks involved, clients should be closely vetted for the appropriateness of giving them access to margin. Unfortunately, brokerages are notoriously lax on this, and will give margin to almost anyone who posts collateral and signs the paperwork.

Accordingly, compliance departments typically require special paperwork and disclosures to ensure that margin accounts are offered only to clients who fully understand the risks, and who have the financial resources to incur possible losses.

The Bottom Line

Although trading on margin can give an investor access to increased amounts of return, the risk inherent is best left to only the most seasoned traders. Losing 100 percent of your investment is bad, but you could potentially owe the brokerage if you borrowed against securities that fail to cover the margin loss.