The old adage of “it takes money to make money” has never rung more true than when it comes to investments. With some research and smart choices, businesses can passively earn income on the funds they hold.
It may seem that investments are a privilege to those who have sufficient capital. But this isn’t necessarily true.
With margin accounts, businesses need less capital to start investing and can maximize the money they earn. Here’s how.
Definition of a margin account
A margin account is a type of brokerage account through which businesses can invest using a combination of their own money and borrowed funds.
The main purpose of a margin account is to open up investing opportunities to businesses that don’t have the capital to cover all the costs of their desired investments. Brokers lend money to help cover the initial investment and charge a periodic interest rate on the borrowed amount.
When the business sells the investment, they pay back the borrowed amount, interest, and any fees that have been accrued. This can also be done with the business’s own capital.
The brokerage holds the investments as collateral. If the business can’t cover the costs of the account, the brokerage takes possession of the securities leaving the business without their investments.
Features and benefits of a margin account
Margin accounts offer a unique opportunity to businesses to invest when they otherwise may not have the capital to do so. Brokers offer this opportunity through a mechanism of borrowing against the investments the business is purchasing.
Some margin accounts also offer the opportunity to borrow against the investments that are currently held. The investments are held as collateral and the funds offered are based on the investment amount.
This borrowing mechanism gives businesses a higher purchasing power meaning they can buy more shares given the cash they currently have on hand.
How does a margin account work?
There are three main mechanisms you need to understand to get the full picture of how a margin account works. These are the three mechanisms.
Leveraging buying power with margin
Margin accounts increase a business’s buying power through lending money to complete investment purchases. The borrowed amount is then paid at a later date.
Say a business has $1,000 they’re looking to invest and they have an option to purchase 100 stocks at $15 per share for a total price of $1,500. With a margin account, they can borrow $500 to complete the purchase and pay it back (with interest and fees) at a later date, likely when they liquidate some of their investments.
If that same investment increases in value by 10% bringing its value to $1,650, the business could then sell it and pay back the $500 meaning they keep $1,150. Through a margin account, the business was able to earn $150 on a $1,000 purchase—a 15% return on their investment.
Keep in mind margin accounts charge interest and fees based on what’s borrowed which will reduce the return on investment (ROI).
Margin requirements and maintenance margin
Before a business can start borrowing from a margin account, they have to meet the margin requirement.
When a margin account is opened, the account holder needs to meet the initial margin requirement. This is essentially a minimum account balance and the initial deposit required to meet it. If the initial margin requirement is 50%, the business would need an initial deposit of 50% of the investment (e.g. $5,000 for an investment purchase of $10,000)
Once the account is active, it needs to maintain a certain balance that meets the maintenance margin requirements. This means a certain level of account equity is required to keep the position open, otherwise the brokerage will request more funds.
To illustrate this, let’s dig into how to calculate margins and how it may trigger a margin call.
Calculating margin and margin calls
Simply put, margin is the difference between the market value of the investments owned and the borrowed amount in the margin account.
Let’s say you’ve purchased $10,000 worth of shares using $5,000 of your own money and $5,000 borrowed in the margin account. Over time, the invest increases in value by 10% to $11,000. The margin has increased from $5,000 to $6,000 ($11,000 in market value minus the $5,000 borrowed).
Alternatively, if the investment were to fall in value to $8,000, the margin would fall to $3,000 ($8,000 in market value minus the $5,000 borrowed).
Margin calls occur when the margin falls below a certain threshold. That threshold is determined as a percentage of the initial investment.
Going back to the example of a $10,000 purchase of shares, let’s say the brokerage has a maintenance margin level of 30%. This means that a margin call will be sent requesting additional funds if the margin falls below $3,000 (30% of $10,000).
If that investment falls below $8,000, the margin falls below $3,000 (based on $5,000 being borrowed) triggering the margin call.
Example of margin account
A business has $5,000 to invest in a margin account. The margin account has an initial margin of 50% which increases their purchasing power to $10,000 ($5,000 of their own capital and $5,000 borrowed).
They invest that $10,000 into various securities. Over the next year, they realize a 15% gain on their investments bringing their account balance to $11,500.
The business decides to cash in at this point and pay back the borrowed amount plus any fees.
The margin account has an interest rate of 10% on the borrowed amount of $5,000. This means that over the year, the account has accrued $500 in interest and fees.
Upon selling, the $11,500 is distributed as follows:
- $500 goes to the brokerage to cover interest and fees
- $5,000 goes to the brokerage to pay back the borrowed amount
- The remaining $6,000 is kept by the business
We can see that after the fees and borrowed amount are paid back, the business earned $1,000 on the investment, a 20% ROI on their initial $5,000 deposit. This is higher than the 15% ROI they would have had if they had invested the $5,000 in a cash account and did not borrow against the investment.
Margin account vs. cash account
Instead of using a margin account, businesses can manage investments through a cash account. Rather than borrowing money to complete the purchase of an investment, the business uses their own cash to front the entire purchase.
When comparing these two options, it’s important to remember that neither are the objectively better option. Both have their pros and cons and will suit better situations.
Let’s break down the pros and cons of using margin accounts.
Pros of using a margin account
- Higher buying power: Using a margin account opens up investment opportunities for businesses that may otherwise not have the capital to invest. Whether it’s making an opportunity possible or maximizing your investment in something promising, a margin account helps you do it.
- Potentially higher returns: Since the margin account holder invests less capital but gets the same return, the proportion of the return to the investment is higher thus netting a higher ROI. This only holds true if the difference is greater than the account fees and interest.
- Opportunity to diversify: By enabling a higher quantity of investments, businesses can spread their capital across a wider range of stocks and shares. Diversifying investments helps reduce risk and the impact of something losing its value.
Cons of using a margin account
- Higher risk when investments fail: Borrowing to make an investment pays off when the investment succeeds, but doubles the impact if the investment fails. If a stock loses its value, you’re still on the hook to pay back the borrowed amount plus fees and interest.
- Interest costs on amounts borrowed: Investments are a waiting game and as time passes, the costs of a margin account accrue in the form of interest. It’s best to approach margin accounts with specific timelines in mind for an expected return.
- Potential margin calls: Margin calls could disrupt your cash flow by creating a sudden need for a cash injection. The tighter your cash flow, the greater the impact this will have on your business.
Choosing the right account type for your investment goals
For a business looking to make investments, the choice of a cash account and margin account will impact how they manage their portfolio. With that in mind, what should you consider when choosing?
The first question you need to ask is what your risk tolerance is. Margin accounts have higher upside, but they come with higher risk as you could lose money on the investment and on borrowing capital.
There’s the added layer of consideration that comes with margin calls. If the margin account is impacted by a margin call and it needs an immediate cash injection, will this disrupt your cash flow? Generally speaking, the tighter the cash flow, the higher the risk a margin account comes with.
The second question you need to ask is what your investment practices will look like. Will someone be owning the account and where the money is invested on a daily basis? Are they familiar with building out a portfolio of investments?
Generally speaking, a margin account is a better fit for people with investment know-how and dedicated time to manage the account. A more passive investment style is better suited for cash accounts.
To make the comparison easier, refer to our table below.
Maximize the capital available to invest
Margin accounts aren’t the only way to obtain the capital necessary to start investing. With some savvy cash flow management, you can increase the amount of money available to put into investments and earn passive income.
With BILL, you get a financial operations platform that helps you manage and maximize the value of every dollar. Control budgets, access credit, and improve AR turnaround times with a full suite of financial tools that make financial management easier.
FAQ
Are margin accounts safe?
Margin accounts are safe and federally regulated. However, margin accounts are a higher risk option and are best suited for businesses or individuals who have experience with investments.
Can you lose money in a margin account?
As with any investment, you can lose money. But if the investment is in a margin account, you can lose additional money through the interest and fees associated with the borrowed amount. This means you can lose more money on an investment in a margin account than a cash account.
What are the costs associated with a margin account?
All margin accounts have interest rates that are determined by the brokerage. As an example, Fidelity’s margin account rates start at 1.250% above the base rate (which hovers around 11%) on account balances less than $25,000 and drop to 3.075% below the base rate on account balances greater than $1 million.
In addition to the interest on borrowed amounts, brokerages may charge fees for opening an account or monthly account maintenance.
What if there isn’t cash to cover a margin call?
If there isn’t enough cash to cover a margin call, the brokerage has the ability to sell investments to make up the difference, locking you in to the loss or gain at the time of sale. For example, if the brokerage sells an investment at a 10% loss, you’ll no longer benefit if that investment recovers to its original market price.
How much can be borrowed in a margin account?
How much can be borrowed in a margin account is determined by the initial margin requirement.
On an initial margin requirement of 50%, you can effectively borrow as much as your initial deposit as only half the account balance must be funded by the account holder.
If you drop the initial margin requirement to 25%, you can borrow up to three times as your initial investment as 75% of the account balance can be borrowed money.
