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A margin account is an account offered by brokerage firms that allows investors to borrow money to buy securities.
How a Margin Account Works
Brokers charge an interest rate on the borrowed money. Also, a maintenance margin is required meaning a minimum fixed dollar amount must be maintained in the account to be allowed to trade on margin. The minimum margin amount is calculated by subtracting the borrowed amount from the account's total equity which includes both cash and the value of any securities.
How Much Can You Borrow?
An investor with a margin account can usually borrow up to 50% of the total purchase price of marginable investments. The percentage amount may vary between different investments and brokers. Each brokerage firm has the right to define which investments among stocks, bonds, or mutual funds can be purchased on margin.
Margin Calls
A margin call occurs when the investments in the account and the cash decrease in value and fall below the minimum maintenance margin amount. The investor must deposit additional funds or sell a portion of the portfolio to fund the margin call. If the investor doesn't fund the account following a margin call, the broker will sell some of the stocks in the account to make up the shortfall. The broker does not need the account holder's approval to sell any shares if the investor does not meet the margin call.
Example
An investor deposits $20,000 into a brokerage account and borrows an additional $10,000 from the broker. The investor has $30,000 to invest. However, the maintenance margin of $7,000 must be maintained between cash and the value of the stocks. As long as the account maintains a value of more than $7,000, the investor will not get a margin call.
However, it's important to remember that borrowing on margin could have consequences. A margin is leverage, which means that both your gains and losses are amplified. A margin is great when your investments are going up in value, but leverage can be a double-edged sword and amplify losses when the market is going down. A margin exposes investors to additional risks and is not advisable for beginner investors, and margins can be a useful tool for experienced investors, though if you're new to investing, it might be more prudent to play it safe.