What is a Margin Loan?

The loan provided by a brokerage house to customers for the purpose of buying stocks on credit is known as a margin loan. The term margin signifies the apparent difference in the market value of the shares that are being purchased and the amount of money that is being borrowed from the brokerage. The interest payable on a margin loan is calculated on a daily basis on the amount outstanding and charged to the margin account.

Over a period of time the amount of the outstanding debt increases and so do the interest charges. The securities are held as collateral for such a kind of a loan. For example if an investor buys stock from the market worth $10,000 but only invests $5000 of his own money, the rest of the money is taken as a margin loan. Although, the process seems to be very straightforward and uncomplicated, but the actual process is not so.

The initial requirement for trading on margin basis is a margin account and for that the law asks for an initial amount of $2000. This is not the standard amount and may increase depending upon the rules and regulations of the brokerage house for an account. This amount is called the minimum margin; once the account is operative you are allowed to borrow the 50% of the value of the stock that you wish to purchase.

However it is not a necessity that you have to borrow the full 50% of the value, you can borrow less too. Your life rolls on smoothly if the stock prices stay stable or increase and you take care of your interest payments.

But what needs to be your concern here is the maintenance margin. The New York Stock Exchange has stated that a person trading on margin needs to at least maintain a 25% of the market value of the securities that are in the margin account. So if stock prices go down that could be a major area of concern for you as some brokerages can demand an even higher percentage than that.

If the prices of the stock fall the balance in your account will fall too and that will make the brokerage ask you to put more cash into it to bring it up to the minimum level. This call from the brokerage’s part is known as a margin call. The brokerage house might even sell some securities that they have with themselves without consulting you to bring the balance of your account to the minimum level. So, you need to be very cautious when you sign an agreement and read all terms and conditions carefully.

The margin accounts are desirable because they allow the investors to have a large bloc of stock at the same time with a less investment. Clever investors use margin loans to build up their personal wealth through the leverage that borrowed money allows.

But as everything has it s pros and cons so do margin loans when the share prices go for a tumble the investor not only is responsible for the money borrowed but also for maintaining a minimum in the margin account. Now the leverage of the money will work in the opposite way and can cause the investor a substantial financial hardship.