Q: What does it mean to invest “on margin.”
By investing “on margin,” you can buy $1 worth of stocks for only 50 cents. That will amplify your gains considerably — but be careful.
Here’s how it works: When you buy securities on margin, you’re borrowing money from your brokerage at a variable interest rate while using the stocks currently in your portfolio as collateral.
As an example, imagine that you hold $10,000 of stocks and you margin that to the max, borrowing $10,000 to invest in additional stock.
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If your holdings double in value, you’ll have earned an extra $10,000 (less interest expense) thanks to margin.
But if your $20,000 of holdings drop by 50 percent, they’ll be worth $10,000 and you’ll still owe $10,000 (plus interest). That will leave you with … nothing.
Your holdings dropped by 50 percent, but margin amplified that to a total loss. Margin cuts both ways.
Investing on margin is tempting, but it’s risky, because if the market turns against you, you either sell for a loss — plus interest costs — or hold on until the market picks up, paying interest all the while.
If you’re borrowing on margin and paying 8 percent interest, you better be pretty confident your stocks will appreciate more than 8 percent, and there’s never any guarantee of that. (Margin rates these days are in the 7 to 9 percent neighborhood, unless you’re quite wealthy.)
When your margined securities fall below a certain level, you’ll receive a “margin call,” requiring an infusion of additional cash.
If you can’t raise the cash, the brokerage will sell some of your holdings to generate the needed funds. This can sting, sometimes resulting in short-term capital gains taxed at high rates.
Margin can reduce your investing flexibility, too. If you’ve borrowed money to invest in a stock and it falls sharply, you may end up forced to sell when you’d rather wait it out.
Only experienced investors should use margin, and many have gotten rich without it, too.