How Margin Accounts Work
A reader asked me awhile ago about my margin account. As you know, I like to use leverage. So when I found out I could own stocks without actually paying for the full amount, I began to think about the possibilities, and opened up a margin account through my discount broker. I simply made an appointment with a financial adviser from my bank to fill out some paperwork. To understand margin accounts, let’s first look at a regular cash account. The portfolio’s value is what the stocks are worth plus any cash balance in the account. Pretty straight forward.
But with a margin account, we can use our stocks as collateral and borrow money against them to buy more stocks. This is similar to using a mortgage or home equity line of credit to leverage against real estate. For example, let’s say we have $30,000 in cash right now and want to buy a house. We can buy a small house that’s worth $30,000 using cash. If the market is hot and our house appreciates by 10% then we make $3,000. If the price goes down 10% then we lose $3,000.
But if we wanted to buy a $100,000 house instead using our $30,000, then we will need to get a $70,000 loan (mortgage.) If the value of our home increased 10% from $100K to $110K then we would make a nice $10,000 profit if we sold it. This return is a lot higher than if we didn’t borrow additional money to invest. However if the house drops in price to $90,000 and we sell it, we would lose $10,000. Using leverage multiplies the gains and the loses. This is basically how a margin account works too.
We can put up just 30% of the total cost of stocks we want to buy and borrow the remaining 70% from the bank. Just like with a HELOC, we have to pay interest on the money borrowed on margin. Last year I told everyone I bought Cineplex (CGX.TO.) Their shares tripled in price over the last decade. And the nature of their business is relatively recession proof (their stock went up over the 2 years spanning 2008/2009.) Below is a screenshot of my Cineplex shares in my margin account.
Unlike a mortgage, we don’t pay down the margin loan over time. The loan percentage (70% in this case) fluctuates with the market value, and we only pay the interest portion of the loan on a monthly bases. I recommend putting dividend generating stocks into margin accounts to help with those interest payments. Cineplex pays a dividend which, after tax, works out to 4.4%. Meanwhile, the interest rate on my margin loan works out to 3% after the tax deduction. So in the end I walk away with the difference of 1.4%. There’s no guarantee that Cineplex will continue to grow in the future. The 1.4% I make is from borrowed capital. Anyone can make a 1.4% annual return with their own money, but not everyone can do the same for themselves using other people’s money. This is why I buy stocks on margin. To increase my chances of success,
This is just an overview of how margin accounts work. But there is much more to it than this. In a future post, I will discuss loan values, margin calls, and other useful ideas for margin accounts besides investing. Buying stocks on margin can be very complicated and risky. It is not for every investor.