Margin Accounts: Playing With House Money?

During periods of economic growth, it’s common to see an increase in margin account use. According to FINRA, margin account debit balance use is up approximately 12% year to date, during which time the S&P 500 has rallied over 18%. Bullish investors and real estate developers alike use margin to leverage immediate liquidity at a more favorable rate than personal loans. But at what cost?

There’s nothing overly sophisticated about a margin account. Essentially, it is a line of credit within an investment account that uses the underlying securities as collateral. You can open a margin account with almost any type of account; however, the most used are that of individual, joint, trust, or business accounts. It is extremely rare that retirement and nonprofit accounts use margin. Not all assets can be collateralized. An exchange traded fund tracking the S&P 500 is likely to be eligible; however, a newly issued security that hasn’t been publicly traded for 30 days may face certain limitations.

The amount you can borrow depends on the fair market value of the collateralized assets. Often the limit is set at 50% of the loan-to-value. For example, if you had a taxable account with $2 million of eligible assets, you could borrow a maximum of $1 million on margin. This borrowing power isn’t free, of course, and it does come with at least one notable risk.

Each financial institution determines its own margin interest rate. This is generally a floating rate correlated to a benchmark like the Federal Funds Rate, LIBOR, or Prime. While annual rate terms are provided to the investor, the interest expense is calculated daily and debited from customer accounts monthly.

The largest risk of using margin is what’s known as a margin call. This happens when the fair market value of the collateralized securities drops. If the value drops below a threshold called the maintenance margin, the account holder must deposit additional funds into the account to bring the loan-to-value back in line. If the investor cannot satisfy the margin call by depositing additional cash, the investor may need to sell some securities. A forced liquidation can be costly for the investor, not to mention the potential tax consequences.

Are you wondering why you’d use margin at all? Margin accounts are most used by business owners, high-net-worth individuals, real estate developers, and other investors who need immediate access to sizable liquidity. Maybe their business needs new equipment or a large sum of money to fund a new housing development project. I’ve even seen retirees use margin as a way to bridge the gap between the purchase of a new home and the sale of their existing one.

Additionally, the tax benefits of using margin responsibly can potentially be substantial. The IRS allows you to deduct margin interest expenses to offset your net investment income earned on a taxable portfolio. For instance, if an investor has a $2 million investment portfolio that generates $60,000 in taxable interest and they incur $100,000 of margin interest, they may be eligible to deduct the $60,000 gain from their taxes.

Any debt associated with risk warrants respect and vigilant monitoring, alongside a well-defined repayment plan. With margin accounts, some of the biggest potential issues involve leverage risk and being unable to satisfy a margin call. However, some investors appreciate the almost effortless access to the funds, variable repayment options, and a competitive interest rate.

Whether or not a margin account is right for you depends on many factors, including your asset profile, access to cash from other sources, and your short- and long-term needs for the liquidity that a margin account can provide. Speak with your investment professional to learn if this investment strategy is right for you.