Margin loans offer quick capital at high risk
Taking stock of margin-loan rules
- Brokerage companies issue margin loans, which are secured by assets in your nonretirement brokerage accounts.
- Margin loans are fast and easy to access, with no fixed repayment schedule.
- If the equity position in your margin loan falls below a set minimum, the brokerage firm can initiate a margin call.
- A margin call requires you to deposit money into your account to make up for a decline in portfolio value.
When it comes to large purchases like a personal home, real estate investment or business acquisition, there’s almost no such thing as fast cash — almost. Investors can tap into their brokerage accounts to access near-instant capital through what is called a margin loan. While margin loans can help investors make well-timed financial decisions, the risk of this arrangement is not insignificant.
A margin loan allows you to borrow through your brokerage firm a multiple of the value of your nonretirement investment accounts. Most brokerage firms allow investors to borrow an amount equal to 50 to 70 percent of their total account value. Margin loans have no fixed repayment schedule and carry variable interest rates that are usually low relative to conventional financing. In fact, rates are typically structured to fall as more money is borrowed.
The primary appeal of margin loans is ease and speed. Most nonretirement investment accounts are considered “margin-ready,” which means investors can apply for and access funds in as little as 24 hours. While a credit check and financial review may be required, they are typically not a barrier to getting cash in hand.
What are margin calls?
There are two major risks to margin loans: interest rates and the market. Because interest rates on margin loans are variable, there is a risk of rates increasing well beyond the initial figure, driving up the cost of the loan.
Market fluctuation is the other substantial risk factor. A margin loan is secured by the investments in your portfolio, whose value rises and falls with the market. To protect themselves against this risk, brokerage firms require that you maintain a minimum balance in your investment account in relation to your margin loan — typically 30 percent of the loan amount. Should a market downturn cause the value of your investments to fall below this minimum equity threshold, the brokerage firm will initiate a margin call.
A margin call requires you to immediately — usually within 24 hours — deposit enough money into the account to restore the minimum equity position for your margin loan. If you do not satisfy this requirement, the brokerage can sell your investments to help recoup the loss. The punitive transaction usually carries a fee and commission charge as well, and it often still doesn’t fully satisfy the outstanding debt, hence the downside risk of a margin loan.
How can I use a margin loan?
A margin loan can be used instead of a mortgage to purchase an investment property or a primary home. Real estate investors frequently use margin loans as bridge financing for a rapid property purchase while the mortgage is being processed. This can be particularly useful in highly competitive markets where cash boosts negotiating power. The interest on margin loans used to finance an investment property may be tax deductible.
There are benefits to using a margin loan to purchase a home as well. As with an investment-property purchase, it can be used as a bridge loan to buy a new house before a homeowner’s existing property sells, or it can be a way to access capital for borrowers who don’t qualify for conventional financing. A margin loan can be used to fund a down payment on a mortgage, for example, although not all lenders will accept such an arrangement.
Using a margin loan instead of a mortgage eliminates many of the fees associated with a home purchase, including closing costs, property appraisal, prepayment penalties and even monthly interest payments. Interest does accrue, however, on both the loan and the interest itself, which can become an unruly sum as time goes on. Given that a personal residence is not considered an investment property and the margin loan itself isn’t secured by the home being purchased, the interest charged on the margin loan is typically not tax deductible.
The primary risk to using a margin loan in lieu of a mortgage is that of a margin call. Market activity is completely out of the borrower’s hands, and no matter how responsible you may be with your finances, should the market lose significant value, you may be required to immediately cough up a considerable sum of money to the brokerage firm. This could require you to make poorly timed sales of other investments, further diminishing your finances.
Should I buy a business with a margin loan?
The benefits and risks of buying a business with a margin loan are similar to a property purchase. Business financing is notoriously complex and time consuming to obtain, if the borrower can qualify at all. The fast, simple process of getting cash from a margin loan can be very attractive.
Purchasing a business already carries operational and revenue risk, and the added volatility of a loan contingent on market conditions can create a very perilous situation. Should a margin call be initiated, you may find yourself facing major losses.
Margin loans are best used as short-term financing to be repaid within six months. If you need more time to pay off the loan, consider other financing mechanisms such as a home equity line of credit. Should you decide to pursue a margin loan, do not borrow the maximum amount your brokerage firm allows. Borrowing only 25 to 30 percent of your portfolio can help mitigate the risk of a margin call.