An investor who wants to increase his or her purchasing power can borrow money from a broker to buy securities. This is called buying on margin. Like any loan, margin loans accrue interest. The rate at at which this interest is calculated is known as a margin interest rate.
The margin interest rate of a loan depends on two factors. The first is the amount of money the investor is borrowing. As with most loans, the more money an investor borrows, the lower the margin interest rate will be. Second, the margin interest rate depends on the broker's call rate, sometimes known as the call money rate, a published interest rate that fluctuates with changes in the economy. It is listed in various financial journals, including the Wall Street Journal and Investors Business Daily. Individual brokers set their rates, usually within a few percent points of the current broker's call rate.
Buying on margin can be a good way to buy stocks and securities that would otherwise be too expensive; however, potential buyers should be aware of all the possible risks. In addition to the set margin interest rate, there are other costs associated with buying on margin. The Federal Reserve Board and self-regulatory organizations like the Federal Industry Regulator Authority have set minimum balances for how much the investor must deposit with the brokerage firm. This is known as the minimum margin. Brokers can increases this minimum if they choose.
At any time after the investor has purchased stocks, the equity in the account must not fall below 25 percent of the current market value of the portfolio. This is known as the maintenance margin. If the equity does fall below 25 percent, the broker can issue a margin call to require the investor to pay the difference. Since the stocks are acting as collateral for the loan, the broker is entitled to sell them without first consulting the investor.
Stocks bought on margin can make a large amount of money because, even after interest and expenses, the profit margin is higher because the full cost of the stocks was not paid out of the investor's pocket. Yet investors should be wary of this strategy. If the value of the stock decreases, the investor still has to pay back the loan and all the fees associated with it. This can result in a loss of more than double what was invested.
