The Pros and Cons of Investing On Margin

With the rise of the retail investor in the past year, investing on margin has grown in popularity. The Financial Industry Regulatory Authority—FINRA—revealed that margin debt soared to $799 billion in January, compared to $562 billion a year ago.[1] Unfortunately for unsuspecting investors, especially those who are new to investing, investing on margin can be a costly venture.

In a nutshell, investing on margin is investing with someone else’s money.

Brokerage firms lend investors funds to buy securities. The buyer only pays a percentage of the asset’s total value and borrows the rest from the brokerage firm—and the brokerage uses the investor’s account as collateral. For example, say you want to buy 100 shares at $100 each for a total of $10,000, but you only have $5,000 in cash. You could purchase the rest of the shares on margin. Not all securities can be bought on margin; they have to be purchased with cash for the total amount. But, according to FINRA, for those securities that you can buy on margin, the investor must provide up to 50% of the total cost based on Federal Reserve Board Regulation T.

Essentially, investing on margin gives investors more purchasing power and the opportunity to make more money if the trade works in their favor. That can be mighty attractive, especially to young investors who don’t have a lot of cash on hand but want to dip their toes into the market.

However, what some investors fail to take into consideration are the interest rates and commissions.

Just like any loan, if you invest on margin, you not only need to pay back the money that you borrowed, but you also have to pay interest—and interest varies by brokerage firm. For example, Charles Schwab has a base interest rate of 6.5%, which they add to a margin rate based on your margin debt. So, interest rates could exceed 8%.[2]

Some brokerage firms also have minimum margin requirements, or the amount of actual cash that you need to hold in your margin account before you can invest on margin. FINRA requires at least $2,000 worth of cash and/or securities to open a margin account. Some brokerage firms may require even more.

In addition, while investing on margin can potentially boost your gains, it can also amplify your losses if a trade goes south. For example, if you bought a security on margin and that security starts trekking lower, your brokerage firm could issue a margin call. This occurs when the value of your margin account dips below the level your brokerage firm requires. The firm can then demand repayment, which could involve you depositing more cash into the account.

If you don’t meet the margin call by adding more funds into your account, the brokerage firm will likely sell your positions to shore up the account. Many brokerages can do this without your approval. So, essentially, a brokerage firm can make changes to your margin account without notifying you first—and you could be charged fees for these transactions, too.

Despite these risks, many investors have not been deterred. As noted earlier, debt margin soared to record highs in late 2020 and remains at these levels today. The elevated level of margin debt has sparked concerns and fears of bubbles on Wall Street. Some investors are even calling for the Federal Reserve to adjust its margin requirements.

The 50% requirement has been in place since 1974. In the decades prior, the Federal Reserve would step in and change margin requirements to ensure that they better aligned with the stock market. But more recently, the Federal Reserve has been hesitant to step in and change the requirement.

Still, given the ballooning margin debt and the GameStop debacle from earlier this year, it might make sense for the Federal Reserve to step in as it has done in the past to cut down on market speculation by increasing margin requirements.

If you have questions about investing on margin and would like to learn more, please give me a call to discuss.

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[1] https://www.wsj.com/articles/how-margin-debt-works-11615136400

[2] https://www.schwab.com/margin/rates