Why Not Use Margin?

Recent data indicate that margin debt has increased significantly over the past 12 years, although it is currently below the peak levels seen in 2000 and early 2014.

Margin is a feature that you can add to a taxable (non-IRA) brokerage account that enables you to borrow money against the value of your investments in the account. Initial margin, or the amount that you can borrow, is generally 50% of the value of the account. On a $100,000 account, you could borrow up to $50,000. The money can be used to buy more investments, or it can be taken out of the account and used for some other purpose.

Say you have an account that contains $100,000 in stocks. You write a check for $50,000 to purchase a new car. You still have stocks worth $100,000 in the account, but you owe the brokerage firm $50,000. Your net equity in the account is $50,000 (the $100,000 market value of your investments minus the $50,000 you owe).

Maintenance margin is the level of net equity which must be maintained in the account. If the equity in the account falls below this level, usually 30% of the account value, then a deposit must be made to the account or investments will be sold to reduce the margin loan balance.

Say the stock market experiences a correction and falls 15%. Your $100,000 in stocks are now worth $85,000. However, you still owe $50,000 to the broker. Your equity in the account is $35,000, or 41%. If the stock market continues to decline and your equity falls below 30%, some or all of your investments will be liquidated by the broker to reduce your margin loan. This is not good timing because you are being forced to sell stocks when they are down.

There are several other disadvantages to borrowing on margin that investors should be aware of. Interest rates are high; particularly when you consider that the lender is fully secured. Currently, the interest rates at major custodians are in the 5.5%-8% range, depending on the amount borrowed. Also, the interest rates are floating, so there is no protection against rising rates. Tax deductibility of margin interest is complex and more restrictive than other interest deductions such as on your home mortgage.

Using margin always increases your portfolio risk, particularly if you use the proceeds to buy more stock. Let’s go back to the previous example of the $100,000 account, but this time you take a $50,000 margin loan and use it to increase your stock holdings. You now have $150,000 in stock and owe the broker $50,000. Your net equity is $100,000. Say the stock market falls 20%; your stocks are now worth $120,000. You still owe $50,000 to the broker, and you’ve lost 20% of 150,000 instead of 20% of 100,000. In other words you have a $30,000 loss instead of a $20,000 loss. You’ve lost 30% of your initial $100,000 on a 20% market decline. Your loss was 1.5 times that of the overall market, plus you paid interest on the margin loan. Not a good outcome.

There are some situations where margin can be appropriate, say for short- term needs where the amount borrowed is a small percentage of the account value. We generally advise against using margin on a longer term basis.

Bill Hansen, CFA

Managing Partner

Bill

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