Margin accounts are accounts that investors hold with brokerage firms, through which the brokerage loans money to the investor. The investor may purchase securities with cash he does not have, by using a margin account to do so. The Federal Reserve limits the amount which may be borrowed on margin to 50% of the value of the purchase. A margin account is necessary when selling stocks short, and is usually used by people who simply want to leverage their investment, rather than people who can’t afford the full purchase price of the securities.
A broker who offers margin accounts will charge interest for the right to borrow the money, although the interest rate is usually very low. The low rate is meant to entice investors into buying on margin, and the securities and cash the investor has in his account function as collateral for the margin loan. Margin accounts are a form of leverage, which means they can be valuable tools for increasing gains. However, they can also increase losses by the same amount, so an investor must exercise caution when buying on margin.
To illustrate in a simplified way how margin accounts can be helpful tools, consider an investor who bought a share of stock for $50 US Dollars (USD), whereupon the market price of the stock went up to $75 USD. If he paid cash for it, the return on his investment is 50% -- a very respectable rate of return. However, if he paid $25 USD in cash and $25 USD in funds borrowed on margin, his return is 100%. He still has to pay back the money he borrowed, but by spreading his margin borrowing over several purchases, he will increase his profits, as long as the price of his stock goes up.
The disadvantage to using margin funds is that they can have the same effect in reverse. If the $50 USD stock falls in value to $25 USD, and it was paid for with cash, half of the investment is lost. But if it was paid for with 50% margin funds, the entire investment is lost, in addition to the amount still owed to the brokerage. It is situations like these that give margin accounts their risk, and somewhat of a bad reputation. In the stock market crash of 1929, many investors’ losses were magnified by the fact that they borrowed heavily on margin- up to 90% in some cases.
Borrowing at these levels is no longer permitted by law, in order to limit downside risk, or an investor’s potential exposure to loss. It is important to know also, that if the value of your investment drops below a certain level, a broker may issue a margin call, requiring you to take action by either putting more money or more stock into your account. Some brokerages will sell your securities without waiting for you, in order to meet the margin call. The best way to avoid this is to be careful and closely watch the value of your account if it consists partly of borrowed funds.