Essentials of Borrowing
Why Buy Stocks on Margin?
Buying on margin means that you are buying your stocks with borrowed money. If you are buying stocks outright, you pay $5,000 for 100 shares of a stock that costs $50 a share. They are yours. You've paid for them free and clear. But when you buy on margin, you are borrowing the money to purchase the stock. For example, you don't have $5,000 for those 100 shares.
A brokerage firm could lend you up to 50% of that in order to purchase the stock. All you need is $2,500 to buy the 100 shares of stock. Most brokerage firms set a minimum amount of equity at $2,000. This means that you have to put in at least $2,000 for the purchase of stocks. In return for the loan, you pay interest.
The brokerage is making money on your loan. They will also hold your stock as the collateral against the loan. If you default, they will take the stock. They have very little risk in the deal. One way to think of buying on margin is that it is often comparable to buying a home with a mortgage. You are taking out the loan in the hopes that the value will go up and you will make money. You are in control of twice the amount of shares. All you have to see is the additional profit exceed the interest you have paid the brokerage. However, there are risks to buying stock on margin. The price of your stock could always go down.
By law, the brokerage will not be allowed to let the value of the collateral (the price of your stock) go down below a certain percentage of the loan value. If the stock drops below that set amount, the brokerage will issue a margin call on your stock. The margin call means that you will have to pay the brokerage the amount of money necessary to bring the brokerage firms risk down to the allowed level. If you don't have the money, your stock will be sold to pay off the loan. If there is any money left, you will be sent it. In most cases, there is little of your original investment remaining after the stock is sold. Buying on margin could mean a huge return. But there is the risk that you could lose your original investment. As with any stock purchase there are risks, but when you are using borrowed money, the risk is increased. Buying on margin is usually not a good idea for the beginner or normal, every day investor.
It is something that sophisticated investors even have issues with. The risk can be high. Make sure that you understand all of the possible scenarios that could happen, good and bad.
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