IF YOU HOLD YOUR INVESTMENTS in a margin account at a brokerage firm, you can typically take out a margin loan equal to 50% of the account’s total value. This is the so-called initial margin requirement, and it effectively allows you to control investments worth twice as much as you could otherwise afford.
A margin loan doesn’t have to be used to purchase additional investments. Some folks use margin loans to buy cars or pay the kids’ college bills, in part because the alternative may be to sell winning stocks and thus trigger capital gains taxes. Your interest costs, however, are only tax-deductible if the margin loan is used to buy taxable investments.
Whatever your reason for borrowing, a margin loan has the potential to boost your returns if the market rises—and magnify your losses if it goes against you. Once you take out a margin loan, make sure your account continues to meet the margin maintenance requirements. Under FINRA rules, a margin loan must equal no more than 75% of your account’s total value. But brokerage firms can impose their own stricter rules, often insisting the loan be no more than 70% of the account’s value and sometimes less.
Suppose you deposited $10,000 in a brokerage account and then borrowed another $10,000 to buy additional stocks, so you controlled $20,000 of shares. If your stocks fall 29%, to $14,200, your $10,000 loan would equal more than 70% of the account’s total value—and, depending on the brokerage firm’s rules, you could receive a margin call.
At that juncture, you would need to reduce the loan as a percentage of the account’s total value by either adding securities or cash to the account or by selling holdings to repay part of the margin loan. Be warned: Your brokerage firm may not call you before selling securities to meet margin requirements, so it’s best to monitor the account carefully and take action before a margin call is a possibility.
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