What is a margin account?

In a nutshell

A margin account is a type of brokerage account that allows investors to buy desired securities on credit, even if they don't have the cash available to cover the entire purchase.

• Margin accounts provide investors with added leverage when buying and selling investments.
• Investors borrow money "on margin" from their broker, and the broker charges interest on the borrowed amount until it is repaid.
• In order to short sell stocks, you usually need to have a margin account.

How a margin account works

There are two types of brokerage accounts to choose from as an investor: cash accounts and margin accounts. With a margin account, you can buy securities — like shares of stock — on margin, which means you are borrowing money from the brokerage firm to cover the purchase and using the existing securities in your account as collateral. This allows you to purchase more than you could if you were only using the cash that you have available in your account.

Margin accounts are a loan from your brokerage. Rather than use your liquidity to fund a purchase, you are able to buy securities on credit. (You can also borrow money from a margin account to do other things, like buy a car, but for the sake of this example we'll stick to using it to trade securities.) You'll then pay the brokerage back the borrowed amount plus interest until the debt is repaid.

For example, say you have 500 shares of XYZ stock in your brokerage account that are valued at $5,000 ($10 per share), and you want to buy more shares of XYZ because you think the business is doing well and the price of the stock will go up. Your broker allows you to buy shares on margin up to 50% of the value of the stocks in your account, so you can use $2,500 to purchase 250 more shares.

After you purchase those shares, the stock price goes up t0 $20 per share, and your account is now worth $12,500 (750 shares x $20) minus the $2,500 you borrowed on margin. You sell 125 shares to pay off the margin balance, and your net profit is $2,500 because you were able to use your margin allowance as leverage.

For more advanced traders, you can also use a margin account to sell securities (often stocks) short. To short stocks, instead of borrowing money from the brokerage to buy stocks, you borrow stocks from the brokerage to sell to another buyer in hopes that the value of the stock will fall, and you will be able to buy back the borrowed shares at a lower price. This is a high-risk, advanced trading strategy, and it is not recommended for beginners.

Repaying a margin account

Margin account loans don't usually have a set repayment schedule in the same way that consumer loans do. However, you will accrue interest on any borrowed amount until the debt is repaid, so it's often wise to keep your margin balance as low as possible.

Let's take the example above. You can either decide to hold onto all of those shares, sell some of them, or sell all of them. If you sell all of the shares, you will have to pay tax on the capital gains, but you will be able to pay off your margin loan immediately. If you don't sell them, they may continue to appreciate in value, in which case, your brokerage may allow you to keep your margin loan for an indefinite period of time. And if the shares pay a dividend, you can use that cash to pay the interest and principal on the margin loan.

What happens if my margin purchase drops in value?

In our previous example, the margin buy turned out to be a great investment — but it doesn't always work out that way. As with all investments, the securities you buy have the potential to drop in value, which can be a problem if you've bought them on credit.

You're still responsible for repaying a margin account even if you buy assets that lose value. Continuing with the example above, let's say the price of your shares in XYZ company falls from $10 per share to $5 per share. Your account is now only worth $3,750, and you owe $2,500 in margin. As stated above, your brokerage only allows you to borrow money up to 50% of the value of the securities in your account, so you will need to add $1,250 to cover the shortfall in your account.

If you don't have the cash to make up the difference, under Federal Reserve Board Regulation T, you have "one payment period," which is currently four business days from the date you traded the stock, to meet the initial margin requirement. If you don't meet this deadline, regardless of whether the stock you purchased on margin moves up or down, you'll get a margin call, which in our example is a request to deposit $1,250 or the firm must liquidate the stocks in your account to pay off the margin debt, according to FINRA, the Financial Industry Regulatory Authority.

Margin account pros and cons

Cash accounts vs. margin accounts

There are two different types of brokerage accounts available to investors: cash accounts and margin accounts.

Cash accounts are standard brokerage accounts; they allow you to deposit funds and then use that credit to purchase securities. Cash accounts are like a prepaid credit card: You can make as many investment purchases as you'd like, up to the deposited balance in your cash account.

Margin accounts, on the other hand, are more like credit cards. While you'll usually still deposit cash in these accounts, you can also borrow from the brokerage to buy more securities than you have in cash. You'll later repay any borrowed amount (plus interest), but this gives you more leverage than your cash alone.

Frequently asked questions (FAQs)

Can I withdraw money from a margin account?

You can withdraw funds from a margin account, but there are often limitations. For example, you are usually limited to withdrawing the cash value of your margin account, usually up to 50% of the value of the securities in your account.

Is a margin account a good idea?

A margin account can be a great way to amplify your investment returns and leverage other people's money to build your portfolio. However, with greater reward comes greater risk. The investments you purchase also have the potential to lose value, amplifying your losses and forcing you to liquidate elsewhere to cover the debt. Additionally, margin accounts charge interest on the amount borrowed, so using these funds will cost you money.

How much money is needed for a margin account?

The minimum requirement for a margin account will vary by brokerage and may depend on personal factors, such as your investor history and total portfolio value. There are also federal regulations that dictate how much equity you must maintain in a margin account at all times.