How Margin Accounts Work
A reader asked me awhile ago about my margin account. As you know, I like to use leverage. So when I found out I could own stocks without actually paying for the full amount, I began to think about the possibilities, and opened up a margin account through my discount broker. I simply made an appointment with a financial adviser from my bank to fill out some paperwork. To understand margin accounts, let’s first look at a regular cash account. The portfolio’s value is what the stocks are worth plus any cash balance in the account. Pretty straight forward.
But with a margin account, we can use our stocks as collateral and borrow money against them to buy more stocks. This is similar to using a mortgage or home equity line of credit to leverage against real estate. For example, let’s say we have $30,000 in cash right now and want to buy a house. We can buy a small house that’s worth $30,000 using cash. If the market is hot and our house appreciates by 10% then we make $3,000. If the price goes down 10% then we lose $3,000.
But if we wanted to buy a $100,000 house instead using our $30,000, then we will need to get a $70,000 loan (mortgage.) If the value of our home increased 10% from $100K to $110K then we would make a nice $10,000 profit if we sold it. This return is a lot higher than if we didn’t borrow additional money to invest. However if the house drops in price to $90,000 and we sell it, we would lose $10,000. Using leverage multiplies the gains and the loses. This is basically how a margin account works too.
We can put up just 30% of the total cost of stocks we want to buy and borrow the remaining 70% from the bank. Just like with a HELOC, we have to pay interest on the money borrowed on margin. Last year I told everyone I bought Cineplex (CGX.TO.) Their shares tripled in price over the last decade. And the nature of their business is relatively recession proof (their stock went up over the 2 years spanning 2008/2009.) Below is a screenshot of my Cineplex shares in my margin account.
Unlike a mortgage, we don’t pay down the margin loan over time. The loan percentage (70% in this case) fluctuates with the market value, and we only pay the interest portion of the loan on a monthly bases. I recommend putting dividend generating stocks into margin accounts to help with those interest payments. Cineplex pays a dividend which, after tax, works out to 4.4%. Meanwhile, the interest rate on my margin loan works out to 3% after the tax deduction. So in the end I walk away with the difference of 1.4%. There’s no guarantee that Cineplex will continue to grow in the future. The 1.4% I make is from borrowed capital. Anyone can make a 1.4% annual return with their own money, but not everyone can do the same for themselves using other people’s money. This is why I buy stocks on margin. To increase my chances of success,
This is just an overview of how margin accounts work. But there is much more to it than this. In a future post, I will discuss loan values, margin calls, and other useful ideas for margin accounts besides investing. Buying stocks on margin can be very complicated and risky. It is not for every investor.
Margin works great, until a black swan happens and your account blows up. If you are using such a high leverage as you pictured on this post, you don’t even need a black swan, a good 30-40% correction will be enough to put you in margin call territory, and then you will be at your bank’s mercy (hint: they have none). If you happen to be lucky and catch a bull market (2000 – 2007), you can be made a millionaire on margin. Bad timing (2007 – 2009), will wipe you out in days.
Great point about black swan events. Risk is greatly increased when margin is used. Hopefully today’s poor market performance doesn’t turn into a major correction, or else I’d need to put some more money in my margin account :0)
Your explanations on margin accounts was very well done. I like the HELOC example that you used to illustrate how they work. Thank you for making it clear for those who are not very familiar with them.
Thanks Anthony ヽ(^。^)ノ
Some people take on HELOCs because of low interest rates. I borrow on margin for the same reason right now.
Great post. I think leverage is a very good idea when your portifolio is smaller, it can boost growth. When your portifolio is bigger (500K+) maybe a good time to start reducing levarage, at least this is my strategy.
Hey Theo. I totally agree. I like to call it the adjustable leverage balance, where the debt/equity ratio should be reduced as the stakes get bigger. It applies to other aspects of investing as well. Going all in on a small cap company with a $1K portfolio is plausible if we can risk losing a few hundred dollars, but for a $100K portfolio we wouldn’t go all in on this company anymore because capital preservation now takes priority over growth, so we have to decrease our investment risk.
I’m definitely not ready for margins yet, but thanks for the info! Can’t wait for more posts on this topic; maybe it will increase my comfort level with leveraging. I know I am definitely a risk adverse person though.
Do you think trading products such as ETFs or index mutual funds on margin make sense? I’m not sure the dividend yield in that case would result in a sufficient return for the risk.
That’s cool Miss V. Women are generally more risk adverse than men, which is actually very beneficial. Studies show women are better long term investors than men for this very reason （＾－＾）
Since ETFs trade the same way as stocks, I have no preference either way. If the ETF or index fund pays a dividend that’s at least equal to the margin loan interest (3% in my case) then I would put it in. However I would warn against putting any inverse ETFs based on the financial sector into a margin account.
Thanks for this it made better sense of my margin account. So far I’ve only used my own cash my having that money there is very tempting. I will need to read my margin account`fine print and see how much interest it charges me. I’m very new at this and I’m actually thinking of changing my margin account to a TFSA investing account. Again, thanks for the info very easy to read for a newbie like me.
Your welcome Ramon. I know what you mean by tempting, especially when interest rates are so low right now. Have you thought about creating a new TFSA account and keep the margin account you have now?
Good informative post! We’ve always turned down the option of margins – probably because we’re not brave enough! I think it’s a great way to take advantage of money the bank is offering to loan you.
For sure Julie. I love borrowing the bank’s money, lol. Some people also like to use margin accounts as a back-up for their emergency fund ( ^^)
I was actually talking about this strategy with a friend today but wouldn’t it make more sense to use this with a stock that has a way higher yield?
Good idea. It certainly wouldn’t hurt having a margin account with high yielding equities in it.
That’s the strategy that I use in my leverage account: In October 2011 when stock prices were falling I decided to use my HELOC to borrow $50,000 and invest in 10 dividend stocks. The interest I pay on the $50,000 loan is 3.5% annually (or $1750 in interest a year). Keep in mind that interest used to borrow for investing purposes is tax deductible! After tax deduction I pay $1000 in interest per year. The stocks I own produce an average yield of 5.5% (some are higher such as CFX at 10%, and some are lower such as Telus at 4.5%). Total dividends I receive annually is around $2750. Without using any of my own money I’m earning: $2750 (dividends) – $1000 (interest) = $1750. Of course that’s before any capital gains. I’ve been fortunate so far and my stocks are up by an average of 20%. So, if I sold now, I’d have made $10,000 without using a cent of my own money. Of course there are two major risks with this strategy: 1) interest rates rise and I send up paying more in interest than I earn in dividends 2) stock market tanks, and I am left owning… Read more »
Thanks for sharing your strategy Rick. In fact, HELOCs are even better for doing these kinds of things because their borrowing interest rate is usually lower than margin loans.
Looking forward to a post on margin calls… how they happen, and what you need to do to cover them.
Thanks for the interest Matt. I’ll probably do a post on margin calls early next month.
Great blog man, had very important content that I can relate to 🙂
[…] money to buy stocks using your existing holdings as collateral. In the past I’ve described how margin accounts work, and walked through how to execute a trade on margin, so I won’t go into that here. This […]