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Online brokers offer two types of accounts: cash accounts and margin accounts. Both allow you to buy and sell investments, but margin accounts also lend you money for investing and come with special features for advanced investors, like short selling. We’ll tell you what you need to know about cash accounts and margin accounts, and help you decide which is right for you.
Choosing a Brokerage Account: Cash vs Margin Account
When you apply for a new brokerage account, one of the first choices you need to make is whether you want a cash account or a margin account.
It’s a bit like the difference between a debit card and a credit card. Both help you buy things and provide easy access to money, but debit card purchases are limited by the cash balance in your bank account while credit cards lend you money to buy more than the cash you have on handâ€”potentially much more.
With a brokerage cash account, you can only invest the cash that you have deposited in your account. Margin accounts extend you a line of credit that lets you leverage your cash balance. This extra complexity can make them risky for beginners.
How Does a Cash Account Work?
A cash account allows you to purchase securities with the cash in your account. If youâ€™ve deposited $5,000, for example, you can purchase up to $5,000 in securities. If youâ€™d like to buy more, you have to deposit additional funds in your account or sell some of your investments.
Notably, with a cash account, your potential losses are always capped to the amount you invest. If you invest $5,000 in a stock, the most money you can lose is $5,000. For this reason, cash accounts are the better choice for new investors.
How Does a Margin Account Work?
With a margin account, you deposit cash and the brokerage also loans you money. A margin account gives you more options and comes with more risk: You get additional flexibility to build your portfolio, but any investment losses may include money youâ€™ve borrowed as well as your own money.
You are charged interest on a margin account loan. Trading on margin, then, is essentially betting that the stocks you purchase will grow faster than your margin interest costs. For instance, if youâ€™re paying 8% APR on a margin loan, your investments would have to increase by at least 8% before you break evenâ€”and only then would you start to realize a net gain.
Margin rates vary by firm, and they can be high. According to Brian Cody, a certified financial planner with Prudent Financial in Cedar Knolls, N.J., margin interest rates are about three to four percentage points higher than what would be charged for a home equity line of credit.
Margin loans generally have no set repayment schedule. You can take as long as you need to repay your loan, though you will continue to accrue monthly interest charges. And the securities you buy in a margin account serve as collateral for your margin loan.
Margin accounts have a few additional requirements, mandated by the SEC, FINRA and other organizations. They set minimum guidelines, but your brokerage may have even higher requirements.
Before you start buying on margin, you must make a minimum cash deposit in your margin account. FINRA mandates you have 100% of the purchase price of the investments you want to buy on margin or $2,000, whichever is less.
Once you start buying on margin, you are generally limited to borrowing 50% of the cost of the securities you want to purchase. This can effectively double your purchasing power: If you have $5,000 in your margin account, for example, you could borrow an additional $5,000â€”letting you buy a total of $10,000 worth of securities.
After youâ€™ve purchased securities on margin, you must maintain a certain balance in your margin account. This is called the maintenance margin or the maintenance requirement, which mandates at least 25% of the assets held in your margin account be owned by you outright. If your account falls below this threshold, due to withdrawals or declines in the value of your investments, you may receive a margin call (more on that below).
What Is a Margin Call?
A margin call is when your brokerage requires you to increase the value of your account, either by depositing cash or liquidating some of your assets. Margin calls occur when you no longer have enough money in your margin account to meet maintenance margin, either from withdrawals or declines in the value of your investments.
Consider this example:
- You purchase $5,000 of securities with cash and $5,000 on margin. Your portfolio value is $10,000, and $5,000 of it is your money.
- If the market value of your investments decline by 40%, your portfolio is now worth $6,000. You still owe $5,000 on a margin loan, so only $1,000 in your portfolio is your money.
- A 25% maintenance margin would require your equity, or the portion of your account thatâ€™s cash, to be at least $1,500 in a portfolio of $6,000. In this case, the brokerage would require you to deposit an additional $500 or sell securities to rebalance the portfolio.
â€œThis is a major risk of margin investing,â€ says Patrick Lach, a certified financial planner and assistant professor of finance at Indiana University Southeast. â€œIt may require the investor to come up with additional cash to maintain the position. This is not an issue with cash accountsâ€”they only require a one-time, up-front investment of cash.â€
The Dangers of a Margin Account
The potential for investments that have been bought on credit to lose value is the biggest risk of buying on margin. While a margin account can amplify your gains, it can also magnify your losses. Having to liquidate stocks during a margin call, because market losses have reduced the value of your investments, makes it very challenging to invest for the long term in a margin account.
â€œWith a cash account, the investor has the luxury of waiting for a stock to recover in price before selling at a loss,â€ Lach says. Thatâ€™s not the case with margin accounts, meaning you may end up losing money on a stock that would have eventually rebounded.
In addition to giving you the flexibility to invest for long-term growth, buying with cash creates a floor for your losses. Whether in a cash account or margin account, investments purchased with cash will only ever cost you the amount you invest.
The Benefits of a Margin Account
While buying on margin can be risky, opening a margin account has certain benefits. There are generally no additional fees to maintain a margin account, and it can be really useful when it comes to short-term cash flow needs.
If you need cash from your brokerage account in a hurry, you may not have time to wait for your broker to sell stocks and deposit the proceedsâ€”settlement can take up to a few days. If you have margin available, your brokerage can give you instant access to cash, which you can back when convenient, either with a cash deposit or by selling securities.
The amount youâ€™d pay in margin loan interest is minimal, so long as you pay it back in a relatively short period of time. â€œThe margin can almost be like an overdraft line of credit,â€ Bishop says.
Margin accounts can be helpful in both up and down markets. In down markets, you donâ€™t have to sell stocks at a loss if youâ€™d rather take a margin loan and wait for the market to recover (just donâ€™t wait too long). When the market is up, margin may help you delay realizing a short-term capital gain, which can trigger high taxes. Taking a margin loan and wait until youâ€™re able to benefit from the lower long-term capital gains tax rates.
Should You Open a Cash or Margin Account?
A cash account will meet the needs of most basic investors. If youâ€™re a novice investor, thereâ€™s little reason to venture into margin trading.
â€œShould the average investor buy stock on margin?â€ asks Scott Bishop, a certified financial planner with STA Wealth Management in Houston. â€œNo, because the average investor buys on greed and sells on fear.â€
You need a margin account in order to sell stocks short, also known as short selling. With this speculative trading strategy, you profit from a decline in a stockâ€™s price. Like buying on margin, short selling is a sophisticated strategy for advanced investors.
That said, a margin account can offer flexibility thatâ€™s nice to have in a pinch. Although trading on margin is risky and only for the sophisticated investor, having a margin account that you can use for short-term cash flexibility can give you the best of both worlds. â€œI see no downside,â€ Bishop says.
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