Margin accounts at brokerage firms allows you to use their stock investments as collateral to take out a loan.
In bull markets, margin loans are more prevalent since stock values are rising. However, when stock values fall, those loans need to be repaid because of the drop in the value of the stocks used as collateral.
[See: Do Bull Markets Scare You?]
Stories of investors getting burned by margin loans have given margin accounts a bad reputation. But financial experts say there are ways investors can benefit from the flexibility margin accounts offer, as long as people use them with care.
Here are three things to know about margin investing:
-- How margin accounts work.
-- How investors go awry using margin accounts.
-- Other ways to use margin accounts.
How Margin Accounts Work
Many brokerage firms offer margin accounts when a trading account is opened and the securities in the account are "marginable," says Jeff Chiappetta, vice president of trading services at Charles Schwab.
The Federal Reserve established margin accounts rules under Regulation T which cover how broker-dealers can extend credit. Every brokerage firm is required to monitor their margin accounts, he says.
Marginable securities include stocks, bonds, exchange-traded funds and mutual funds, but there are nuances, Chiappetta says. For example, a stock that just had an initial public offering, or IPO, might not be available for margin use for at least 30 days.
Regulation T says investors can borrow up to 50% of the purchase price of eligible securities, but brokerage firms may have stricter regulations about how much can be borrowed against a certain security, he says.
Brokerages may limit how much an investor can borrow against volatile stocks to reduce risks.
Brokerages may also change margin requirements on accounts or individual securities if the firm feels uncomfortable with the risks of the securities. It doesn't happen often, Chiappetta says, but when it does, the firm will issue a margin call, which means the investor must deposit money or sell securities to cover the shortfall.
How Investors Go Awry Using Margin Accounts
Investors who use margin loans to buy additional securities hope to magnify their gains with leverage, but losses are also increased, says Timothy Hooker, co-founder and accredited investment fiduciary at Dynamic Wealth Solutions. Loading up on margin loans can get investors in trouble.
"If you're an experienced trader and know what you're doing, there's nothing wrong with using margin," he says. "But if you're really trying to take your account to the moon and back, then that's where you can blow up your account and really derail your financial plan."
John Person, founder of Persons Planet, a trading education and advisory service company, says a good rule of thumb is not to borrow more than 25% against eligible assets, and he recommends keeping the debt-to-equity ratio in an investment portfolio closer to 15% to 20%.
"A small amount of your portfolio can be used to extract cash for small loans," Person says. "Borrowing more than 25% of your total portfolio is ludicrous because the market can go down."
A margin call can happen when account values fall under 50% equity, so keeping margin levels low allows investors to control their leverage.
But Person says when investors see their portfolio equity fall in a down market and their debt levels increase because of margin loans, it can be hard to stomach.
"Even if they don't get a margin call, psychologically it is a big impact that affects people," he says. "They see their assets devalue, then they panic and they tend to liquidate."
Other Ways to Use Margin Accounts
Clients who use margin loans are usually tapping them for short-term liquidity purposes, rather than buying risk assets on loan, says Jared Snider, a senior wealth advisor at Exencial Wealth Advisors.
"Most of my clients use a margin account as an interest-only loan, often for bridge purposes," he says.
Real estate deals where someone is buying a property but is also waiting for a property to close might tap a margin account to be able to bring cash to close the deal on the target property.
"A margin loan is a great way to do that," Snider says, as it may be preferable to selling highly appreciated securities and taking the tax hit.
Margin loans have no payoff schedule and access to cash is immediate since all the paperwork was filled out when the investor opened their brokerage account, Snider says, which is a benefit versus applying for a bank loan. Interest accrues during that time, although that interest can be tax-deductible for people who itemize.
These loans have higher interest rates than bank loans and are based on tiered rates.
"You're paying higher rates because of the flexibility component," Chiappetta says, adding that the rates are variable.
Typically, brokerages will change rates when the Fed makes changes to monetary policy.
Person and Snider both recommend investors pay back margin loans quickly because of those higher rates. To do so, investors can add cash or sell securities.
Even though buying stocks on leverage adds risk, Person says it can be a good short-term investing tool for people who use it carefully.
Sometimes experienced traders use margin to bet on a stock with strong momentum and then take profit when price movements slow.
Some traders use it to buy index ETFs that pay dividends to amplify the income return. But to do so, a trader needs to keep a sharp eye on the market, Person says.
"You need to make sure that whatever market you're in doesn't stagnate," he says. "Because if you're stagnating, you're not receiving a net return. Instead, you have a loss from the interest that you're paying on the money that you borrowed."
Chiappetta says people who use margin accounts need to stay on top of their portfolio.
"A big risk is that clients don't stay engaged and they lose track of where their equity-to-debt ratio is, and then they're surprised when the market doesn't go the way they were expecting," he says.
Debbie Carlson has more than 20 years experience as a journalist and has had bylines in Barron's, The Wall Street Journal, the Chicago Tribune, The Guardian, and other publications. Follow her on Twitter at @debbiecarlson1.