Learn How Margin Loans Work
These are loans taken to finance the purchase of securities, usually the purchase of stock (also known as equity). Margin loans normally are extended by the same financial services firm (stock brokerage firm or securities firm) that the customer uses to trade in the security in question.
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. A "margin call" 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. For examples, see this discussion of Margin 101.
- 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% gain, exclusive of commissions, fees, and taxes. Buying the same security with 50% down in cash ($5,000) and 50% obtained through a margin loan ($5,000) would yield a 200% net gain (after paying off the $5,000 margin loan), exclusive of commissions, fees, taxes and interest on the loan.
- 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% loss. However, a client who bought the security on 50% margin would suffer a complete 100% 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.
- Vetting Clients: Because of the risks involved, clients should be very closely vetted for the appropriateness of giving them access to margin. 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.
- Stock Loan: 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. See our articles on stock loan and SEC Rule 15c3-3 for more details.
Also Known As: securities loan
Example of Using the Terminology: I bought 100 shares of IBM on margin, with a loan from my brokerage firm.