If you own a portfolio of stocks in a taxable brokerage account, i.e. not an IRA, Roth IRA, 401(k) or other tax deferred account, then you’ve got access cash when you need it in the form of a margin loan.
In short, with a margin loan, your brokerage firm will lend you up to 50% of the value of the securities held in your account. Some brokerage firms loan less, and some securities can’t collateralize margin loans, but 50% is a good rule of thumb. The advantages of margin loans are three fold.
First, they’re easy. No proof of income. No tax returns, deed, proof of title insurance or a nosy bank officer asking where certain deposits came from or went.
Second, because of the above, margin loans are fast. All they require is a call to your broker and with some brokerages, make a draw online.
Third, there’s no set amortization or payback period. You’ll be charged interest each month, but in terms of the principle, you can pay it back when it’s convenient to you.
Finally, because margin loans are not underwritten in the conventional sense of the word, and are relatively risk-less for the brokerage, they tend to be cheaper than conventional bank loans. Typically, the more you borrow, the lower the rate.
The big drawback to margin loans is the possibility that the underlying securities collateralizing the loan fall below a certain level, resulting in a so-called “margin call” to put more cash in the account. If you don’t have the cash, the brokerage firm will sell some of your securities to get you back to what they call a maintenance level, which is often 30%
Here’s an example. Suppose you have $10,000 in a brokerage account and borrow $5,000 on margin. Further, if the $10,000 in securities falls in value to $6,000, your equity your brokerage account is now $1,000 ($6,000 in securities – $5,000 in margin debt). If your broker’s maintenance requirement is 30%, you need to have $1,800 in equity (30% of $6,000). Since your equity is just $1,000, you will receive a margin call to put another $800 of cash into the account.
If you don’t have the cash, the brokerage firm will sell some of the securities in the account to bring the maintenance requirement up to the proper level. This will be more expensive than it first appears because the sale of securities will provoke a capital gains tax or a loss.
The way to protect yourself against this eventuality, is to borrow small amounts, say 15% of the value of your account. If you had $100,000 in a brokerage account and borrowed $15,000, the required equity would be $25,500 with a 30% maintenance requirement. In the scenario, the value of your account would have to fall by 75% before you received a margin call.
During the Great Recession the Dow lost about 50%. Not a happy conjecture that it might happen again, but if it did, and you kept your margin borrowings to a minimum, at least you wouldn’t suffer a margin call. In fact, you might even have some borrowing capacity left, and if things really go south, you might need the money.
An example: Assume you own $5,000 in stock and buy an additional $5,000 on margin, resulting in 50% margin equity ($10,000 in stock less $5,000 margin debt). If your stock falls to $6,000, your equity would drop to $1,000 ($6,000 in stock less $5,000 margin debt).
If your brokerage firm’s maintenance requirement is 30% (30% of $6,000 = $1,800) you would receive a margin call for $800 in cash or $1,143 of fully paid marginable securities ($800 divided by (1-.30) = $1143)—or some combination of the two—to make up the difference between your equity of $1,000 and the required equity of $1,800.