You're probably familiar with the idea that with higher risk can come higher reward.
Margin loans are one of the most emblematic Wall Street devices where this statement holds true. They can massively increase your profit, or they can dig you into a hole very quickly.
Take Archegos Capital Management, for example. It was a family office that borrowed on margin and then lost billions when some of its bets declined and it couldn't meet margin calls.
We'll cover more on dreaded margin calls below, but for now, suffice it to say that if the pros can get it wrong, so can you. That's not to say taking a margin loan from your broker is always a bad idea. You just have to know how to use that debt judiciously.
Here are some questions you need to ask before using brokerage margin loans:
-- What is a margin loan?
-- What is a margin call?
-- How much can you borrow with a brokerage margin loan?
-- What are the benefits of borrowing on margin?
-- What are the risks of borrowing on margin?
What Is a Margin Loan?
A brokerage margin loan is a type of secured loan. Your brokerage firm uses investments in your account to secure the loan. The idea is that if you don't pay as agreed, the broker has the right to seize those assets to help cover what you borrowed.
Each broker that offers margin loans has its own terms. In general, though, brokers have a list of investments, usually stocks and bonds, that are considered "marginable." These marginable investments can be used as security for a loan.
You can use margin to buy more stocks than you would normally, allowing you to boost what you could buy. It's also called leveraging your account, and you can use the money for other purposes than buying stock.
For example, let's say you have $10,000 cash in your brokerage account. You decide you want to use a brokerage margin loan to increase the amount you can buy. If you buy a maximum of 50% allowed by the broker, you could get $20,000 worth of investments. You pay your $10,000 in cash to buy assets, and the brokerage matches by providing another $10,000 worth of assets. Now, instead of stopping at a portfolio worth $10,000, you have a portfolio worth $20,000.
What Is a Margin Call?
Your margin loan is based on the value of the assets in your account. However, market assets, especially stocks, fluctuate in value. As a result, if the value of your portfolio drops to a certain point, your broker can issue a margin call.
You're required to keep your portfolio value at a certain level of marginable assets. If your account value drops below that threshold, the broker will ask you to either add more marginable assets to the portfolio or add cash to your account. You have to add the amount needed to bring your account value back in line with the requirements to maintain the brokerage margin loan.
Tim McGrath, managing partner with Riverpoint Wealth Management, notes that margin calls can force investors to sell shares at a bad time -- when the market is down -- instead of being able to hang onto them and sell at a more profitable time.
"Just when you might want to buy more, you are forced to sell," says Stanley Kon, editor-in-chief of the Journal of Fixed Income and chairman of financial software company Ripsaw.
How Much Can You Borrow With a Brokerage Margin Loan?
Generally, brokerages that offer margin loans will allow you to borrow up to 50% of the price of marginable securities like certain stocks, bonds and mutual funds in your brokerage account.
McGrath says he would never recommend that a client borrow up to that 50% limit. If you're at the limit, even a small decrease in the market can lead to you getting hit with a margin call.
In general, interest charges for margin is lower than what you'd see with a credit card or a personal loan. Margin interest is tallied up monthly, based on the amount of your loan and the rate charged by the broker. You can pay down your principal on your own schedule, and that will affect the interest you pay.
The Benefits of Borrowing on Margin
By allowing you to buy more securities than you could otherwise afford, margin loans can magnify your portfolio gains. And margin loans can help you out if you're short on cash outside of the stock market.
McGrath says margin loans can make sense on a short-term basis as long as investors aren't near their 50% limit.
For example, they might make sense for someone who has bought a new house that closes before the old house, leaving them in need of cash for a short period of time.
But McGrath doesn't recommend using margin loans to leverage portfolios, which are already risky enough without adding the risk of a margin call. If the market goes up, you could make a lot of money, but if the market goes down, "it could be a disaster," McGrath says.
The Risks of Borrowing on Margin
If your investments tank and you don't have enough money to meet a margin call even after you've sold your margined securities, you'll still owe the brokerage, forcing you to come up with cash or marginable securities some other way.
"Using leverage is wholly inappropriate for the vast majority of individual investors," says Robert Johnson, finance professor at Creighton University. "While leverage magnifies gains, it also magnifies losses, and large drawdowns in the market can lead to enormous losses to leveraged investors, forcing them out of positions."
Johnson notes that many investors think leverage is a good idea because they see sophisticated investors such as hedge funds using it. But he notes that hedge funds are employing leverage using other people's money. Recall the example of Archegos Capital Management. Banks that extended margin loans to the family office ended up losing billions.
"When these hedge fund bets are correct, the hedge fund manager wins," he says. "When these hedge fund bets are incorrect, the hedge fund investors lose. Gambling with other people's money is good work if you can get it. Gambling with your own money is perilous."
You can reduce your risk by borrowing less. Instead of borrowing the full 50%, it might be better to limit margin loans to a lower percentage of marginable assets. Some investors limit their margin to 25% to 35% of their marginable assets in order to keep a lid on potential losses and reduce the chances of a margin call.
Kon notes that achieving similar leverage to a margin loan can be accomplished via other avenues that don't involve the threat of a margin call. Investors could employ call options on stocks with embedded leverage or use other debt sources such as an unsecured bank line of credit, home equity line of credit or second mortgage.
"Another approach is not to borrow," Kon says. "Instead, sell other investments that are less attractive to fund the more attractive investments and/or forgo some current spending in order to invest."