Should You Rely On Margin Loans From Your Broker?

Jun 09, 2023 By Susan Kelly

You are surely aware of the concept that there is a correlation between increased risk and increased potential profit. This assertion is correct about one financial instrument that has become almost synonymous with Wall Street: margin loans. They can raise your profits greatly but also put you in a financial bind.

Take, for instance, the company Archegos Capital Management. It was a family office that borrowed on margin and then lost billions of dollars when some of its wagers failed to pay off, and it could not fulfill the margin calls.

When it comes to those dreaded margin calls, we'll go into more detail later on, but for now, let's say that if the professionals can get it wrong, so can you. Taking out a margin loan from your broker is not always a terrible decision because of this, though. You only need to be aware of how to use that debt responsibly.

Margin Loans: What Are They?

A margin loan from a stockbroker is a secured loan. The loan from the brokerage business is collateralized by the assets in your account. If you fail to make payments as promised, the broker may take legal action to recover any assets pledged as collateral. Several brokers provide margin loans on different conditions. However, brokers often maintain a list of "marginal" assets, including stocks and bonds. These marginal assets can be pledged as collateral for a loan.

Using margin, you can increase the number of shares of stock you purchase. This is similar to the concept of "leverage," not limited to stock purchases.

Take your $10,000 brokerage account balance as an example. To expand your purchasing power, opt out of a margin loan from your broker. You may invest $20,000 if you purchase the maximum your broker allows, usually 50%. When you invest $10,000, the brokerage will provide you with an additional $10,000 to use in making your investment. You have doubled your previous portfolio value from $10,000 to $20,000.

Can You Borrow A Lot Of Money With A Margin Loan From A Broker?

Brokerages that provide margin loans typically let investors borrow up to half the value of marginal assets in an account. McGrath claims he would never advise clients to take out a loan of up to 50% of their annual income. If you're close to your margin need, any drop in the market might trigger a margin call.

Margin interest rates are often lower than credit card or personal loan rates. Interest on your margin loan is calculated monthly depending on the principal borrowed and the interest rate set by your broker. Your interest will change depending on how quickly you reduce your principal.

Advantages of Margin Loans

Margin loans can increase your portfolio's returns by allowing you to purchase more securities. And if you're short on funds but want to invest in the stock market anyhow, a margin loan can assist.

McGrath argues that short-term margin loans make sense if investors aren't dangerously close to their 50% limit.

They might be useful for someone in a temporary cash crunch, such as when buying a new home that closes before the old one.

However, McGrath does not advocate leveraging portfolios with margin loans due to the inherent risks involved. You stand to gain substantially if the market rises, but if it falls, "it could be a disaster," as McGrath puts it.

The Risks Of Borrowing On Margin

If your investments fail and you do not have enough money to satisfy a margin call even after selling your margined stocks, you will still owe the brokerage; thus, you will be required to come up with cash and marginable securities through other means. Alternatively, if your investments do not fail, you will not be required to meet a margin call.

According to Robert Johnson, a professor of finance at Creighton University, "the use of leverage is completely inappropriate for the overwhelming majority of individual investors." "Leverage magnifies gains, but it also magnifies losses and significant drawdowns in the market may result to enormous losses for leveraged investors, forcing them out of positions." In contrast, leverage does magnify gains; it also magnifies losses.

According to Johnson, many investors consider leveraging a sound strategy because they observe more experienced investors, such as hedge funds, utilizing it. However, he observes that hedge funds use leverage by investing money that belongs to other individuals. To illustrate, let's look at the case of Archegos Capital Management. The family office's margin loans resulted in billions in losses for the banks who lent them.

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