If you haven't saved up much money to invest yet, buying on margin can make your money go further. Once you deposit money in a brokerage margin account, your broker will not only invest it in stocks or bonds for you, she'll let you borrow from her firm to buy more bonds. Buying on margin can jump-start your investment portfolio, but you run the risk of losing more than your original investment.
How It Works
Once you set up your account, you buy bonds using the combined power of your deposits and your broker's loan. If you put in $3,000 and your broker loans you $3,000, you can turn around and buy $6,000 worth of bonds. Your rate of return is much higher than if all $6,000 came from your own pocket, even though you have to repay the loan eventually, along with interest and brokerage fees. You can buy federal bonds, municipal bonds and corporate bonds on margin.
The margin is the percentage of the bond value you have to keep in your account. Federal bonds are so safe that you only need 5 percent of the value to buy bonds that mature in 20 years or less, or 10 percent for longer periods. Convertible corporate bonds, which are riskier, require a 50 percent margin. You also need "maintenance equity" in your account as long as you own the bonds: With convertible bonds, for instance, your account must contain a reserve equal to 30 percent of the bond value.
Bonds are a safer investment than stocks, but they're not risk-free. Convertible bonds offer a high rate of return because the issuers aren't financially sound, so there's a high risk of default. If you come out losing money on a deal and can't pay back your broker's loan, the broker can take money from your account to settle the debt or sell any stocks and bonds you deposited as collateral. If your account falls below maintenance equity levels, the brokerage can make a "margin call" -- either you deposit more money to restore the equity or the broker starts liquidating your account.
Buying stocks on margin contributed to the 1929 stock market crash, which is why the government has regulated margin buying ever since. The federal government sets your margin and maintenance requirements, along with other restrictions: When you open an account, for instance, you have to deposit at least $2,000 as collateral. Your brokerage has the right to set higher requirements or increase the maintenance equity if it thinks your investments are looking too risky.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.