Apr 092012
 

If you’re not familiar with how margin accounts work, you can read this other post first. We’ve already seen how a margin account is similar to getting a mortgage or a home equity loan (HELOC.) Today we’ll discuss margin loans and how to avoid a margin call.

A conventional mortgage requires a 20% down payment which means the bank is willing to give out 80% loans. Why 80% and not 60% or 100%? Because a 60% loan doesn’t make them as much money and 100% is simply too risky. It’s not practical for people to buy homes with 0% down. What if the home’s value drops and the buyer walks away? Margin accounts work in a similar way. Lending is based on the risk that banks are willing to take. So how much money can we borrow in a margin account?  The actual answer is it depends on what stocks we buy. Some stocks are relatively safe, but others are extremely risky. So banks have organized stocks into a few different lending groups. The safest, defensive group will have a 70% lending value. More risky companies will get a 50% or lower lending value, and for the really risky companies, 0%, (ie: we can’t use any margin money to buy them.) Stocks are always moving so sometimes a company’s lending value will change from one group another, but the bank will notify their clients if this happens. Each bank should have a list of stocks and their respective lending values.

If it’s risky for the banks to lend us money to speculate on stocks, then why do they even offer this service in the first place ಠ_ರೃ ? The reason is the same for why banks give people mortgages. For us, a margin account is a way we can use leverage to increase our profits in the stock market. But for banks, a margin account is a debt instrument they use to earn recurring interest. If we buy stocks using more money than what we deposited in our margin accounts we have to pay monthly interest to the bank on however much money we’ve borrowed. So banks want to make money, but they have to be careful not to take on too much risk. Just like a mortgage, banks don’t care if the price of our stocks (or homes) appreciate or not. They only make money on the interest from lending us money.

The amount of available margin money we can borrow fluctuates everyday because its based on the market value of the shares we hold. If we have $100,000 worth of stocks today with a 70% lending value then our available margin is $70,000. But if the market value of our stocks dropped to $90,000, then the bank can’t lend us $70,000 anymore because $70,000 of a $90,000 asset is 78%. That’s higher than 70%, which means too much risk. So at $90,000 our margin amount changes to $63,000. So we should never max out our margin usage in case our portfolio losses value. As soon as the lending amount crosses over 70% we would get a call like the following “hello, this is your broker, could you please put more money into your account or sell some stocks to bring the lending amount back down to 70% or below.” If we ignore this margin call and don’t take any action, then the broker will sell our stocks for us because if we leave the country and our stock goes to zero, then they are on the hook for that $70,000. Selling our stocks is how banks and brokerages protect themselves.

The way I like to use margin accounts is to buy stocks on margin but not borrow so much that I’ll risk getting a margin call. So if the maximum I can borrow is 70% of my holdings then I’ll only borrow up to 40% or 50% so I have some extra margin wiggle room. Later this week, I’ll walk through a recent transaction in my margin account (゜∀゜)

 

conventional mortgage – a mortgage that isn’t more than 80% of the purchase price of a home.
lending value – this is the “up to” amount. 70% means a maximum lending ratio of 70% but we can borrow less if we want to. Note: US and Canadian lending values are different due to separate regulatory bodies. A list of 70% lending value Canadian companies can be downloaded here (PDF.)
margin call – When the broker demands the investor deposit more cash into their account to cover possible losses. Investors can also sell their existing shares which will increase the cash amount in their accounts. Either way, the point is to decrease the lending value back to a safe amount.

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Olga F. HoneaChristopher @ This That and The MBALiquid IndependenceNot Working Recent comment authors
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So if i understand correctly you buy 1500$ for each 1000$ in your account right?

Liquid
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Assuming the stock has a lending value of 70% then yup, we could. For 1000$ in our account we could also buy 1$ of stocks, or 1000$, or 2500$, or any other amount not exceeding our maximum borrowing capacity. In the example you mentioned it’s like buying a 1,500$ house when we only have 1,000$ in cash. We just need to get a 500$ mortgage, or in this case, a 500$ margin loan. No problem ^_^ If we do that then our cash balance in our margin account will be -500$ meaning we owe 500$. Instead of paying off this loan over time though, the 500$ debt stays there and we only pay the interest on it. But if we wanted to pay it off, we just need to deposit 500$ into our account at any time and our cash balance would go back to 0$, like paying off a mortgage. If we purchased 2000$ of stocks with our 1000$ then we would just be taking on a bigger loan (1000$.) The maximum we can borrow is 70% of the total value of our stocks. So if we have 1500$ of stocks we could borrow up to 1050$, but if… Read more »

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i am not sure to understand correctly sorry for my questions ( 0 – 0 ) … so i you have 1000$ in your account you can purchase up to 3333$ but what you recommend is not to purchase more than 50% of that limit ? so 1666.50$?

Liquid
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Pretty close. We can buy 3333$ because 70% of 3333$ is 2333$. So we can borrow a maximum of 2333$ as long as our stocks have a market value of 3333$ or more. Once we add our own 1000$ to the 2333$ we get 3333$ of total stocks. Instead of borrowing the maximum 70% though, I would recommend 50%. So I would probably buy around 2000$, instead of 3333$. If we buy 2000$, that means we use up all of our own 1000$, plus we have to borrow 1000$. Since the bank is giving us a loan of 1000$, and our total stocks are worth 2000$, they are giving us a 50% loan. Basically half and half, we pay half, the bank pays half. 50% will give us some wiggle room, because the stocks we just bought today for 2000$ could be worth just 1500$ tomorrow, but we would still owe the bank 1000$. If that’s the case then the bank’s lending amount becomes 66.7% (1000$/1500$), not 50% anymore. If that happened I would put more money in because 66.7% is pretty close to 70%. If it goes above 70% one day then we will get a margin call. Later… Read more »

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thanks alot for the information!!! i was looking at this recently and was asking myself if it was worth it to invest in stocks that pay around the same amount as the interest in dividends, can’t wait to look at what you do !

Christopher @ This That and The MBA
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Using margin is very risky and I would try to avoid it. But there is also the possibility of high risk having high reward. Good post and illustration

Liquid
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Thanks for pointing that out. Using margin money is risky because it is a form of leverage.

Olga F. Honea
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I really liked your blog! It helped me alot… Awesome. Exactly what I was looking for. Thanks!

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Quick Question can you tell me if you can withdraw money from your margin ?

Liquid
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Yes. Up to the maximum lending amount, which will depend on the value of stocks and cash you have in the account. Similar principle to borrowing money against your home, the maximum home equity loan depends on how much your home is worth. To withdraw, all you have to do is make a transfer, same way you transfer money from your checking account to savings account, for example. Then use the money for anything you want. I can borrow from my margin account at 4.25% to pay off a credit card or student loan debt at a higher interest rate.

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Exactly what i am looking for, i want to deposit, buy stocks and withdraw 40% of margin to cashout to pay debt with higher % like my credit card at 12%