What are Margin Loans?

by Bert Markgraf, Demand Media Google

    When you buy something in a store, you give the seller money and you leave with what you bought. There are no further obligations. Buying stocks or bonds works differently. You invest your money, but usually your broker keeps the shares or bonds for you. The broker can use them as collateral to lend you money. Such loans are margin loans. They are almost risk free because the broker can always sell the shares or bonds and recoup the money if you default. You can use money from margin loans as you please, but most borrowers apply them to other investments.

    Limits

    In theory, you can buy stock, borrow the full amount back, and buy more stock. If you kept doing this, you could acquire a huge portfolio without actually putting up any money. This works until the stock price goes down and your broker no longer has enough collateral for your loans. To avoid the possibility of huge losses for you or your broker, the government enforces limits on margin loans. In general, a 50 percent limit applies at the time of purchase. The broker also applies limits to protect himself, and won't let you borrow the full value of your investments. The actual margin the broker requires depends on your financial situation.

    Calculations

    A 50 percent margin means you can double the amount of your investment. You put in $500 and your broker buys $1,000 worth of stock. He buys the extra $500 on margin, the margin being 50 percent of the $1,000 total. Effectively, you pay $500 and borrow the other $500 to get the full $1,000 investment. You have to pay interest on the $500 loan and, if your stocks lose value, you still have to pay back the full $500. If you don't pay it back as agreed, the broker will sell your stock and keep $500 plus any expenses he had.

    Minimum Margins

    The 50 percent requirement applies when you first purchase the stock. Its value may go up or down from there. The margin becomes the difference between the value of your investments and the loan. If you had $1,000 worth of stocks and a $500 loan, and the stock value dips to $750, the margin is only $250. The percent of the stock value slipped to 33 percent. During this time, the broker will apply a minimum margin requirement to the account. It can vary with your amount of risk, but it's usually between 30 and 50 percent.

    Margin Calls

    If the value of your investments decreases substantially, your margin may drop below the broker's minimum margin requirements. He could raise that minimum if an investment becomes riskier or your financial situation changes. In either case, the broker will want you to pay back some of the margin loan to bring your account up to the minimum margin. If your $1,000 investment shrinks to $500, you have no margin left since you owe the full $500. Your broker may ask you to pay back $250 of the margin loan. You still owe him $250 on stocks worth $500, so your margin is back up to 50 percent.

    About the Author

    Bert Markgraf is a freelance writer with a strong science and engineering background. He started writing technical papers while working as an engineer in the 1980s. More recently, after starting his own business in IT, he helped organize an online community for which he wrote and edited articles as managing editor, business and economics. He holds a Bachelor of Science degree from McGill University.