Buying on margin is a way for investors to increase their buying power without having the cash on hand. It is effectively a loan from the brokerage firm, with the stock within the account used as collateral. Both the loan and interest on the loan must be repaid to the brokerage firm. The problem for investors is when the value of the collateral is less than the loan and the brokerage firm calls in the loan.
Understand How Margin Works
When you open a margin account, the brokerage firm will require a cash deposit. The cash deposit, plus your loan from the firm, is then used to buy securities. If the value of your investment rises, you can sell it, pay back the loan with interest, and keep your profit. However, if the value of the investment falls, the brokerage firm can call in the loan by demanding immediate repayment. To make this payment you must either have other cash on hand, sell investments that are outside the margin account or sell the investments in the margin account plus make up the difference in cash.
Negative Credit Report
Loans made by brokerage firms are no different than loans made by other lenders. If you default on your margin debt, the brokerage firm will file a negative report to the credit bureaus that could make obtaining a future loan difficult. Additionally, if you can obtain a loan, it could be more costly, because bad credit risks are typically charged a higher rate of interest.
Future Margin Accounts
You may have difficulty obtaining a margin account in the future because of the negative credit report. Depending upon the standards at a brokerage firm, you may only get a margin account by making a large cash deposit and/or agreeing to a high rate of interest, while other firms may simply deny your request.
Other Possible Consequences
Like any other loan, an unpaid margin loan from your brokerage firm can result in legal action against you. If you have other investments at the brokerage firm, you can be forced to sell them to cover the margin debt. Or the firm can sell those other investments to cover the loan without asking your permission.
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