Buying Stocks With Borrowed Money
"Margin" is borrowing money from your broker to buy a stock and using your investment as collateral. Investors generally use margin to increase their purchasing power so that they can own more stock without fully paying for it. But margin exposes investors to the potential for higher losses. Here's what you need to know about margin.
buying stocks with borrowed money
The downside to using margin is that if the stock price decreases, substantial losses can mount quickly. For example, let's say the stock you bought for $50 falls to $25. If you fully paid for the stock, you'll lose 50 percent of your money. But if you bought on margin, you'll lose 100 percent, and you still must come up with the interest you owe on the loan.
As with most loans, the margin agreement explains the terms and conditions of the margin account. The agreement describes how the interest on the loan is calculated, how you are responsible for repaying the loan, and how the securities you purchase serve as collateral for the loan. Carefully review the agreement to determine what notice, if any, your firm must give you before selling your securities to collect the money you have borrowed.
Do you know that margin accounts involve a great deal more risk than cash accounts where you fully pay for the securities you purchase? Are you aware you may lose more than the amount of money you initially invested when buying on margin? Can you afford to lose more money than the amount you have invested?
The second problem with borrowing money to buy stocks is that you should only do it if you are absolutely sure that you can ride out the extra volatility. In the last two major bear markets, from 2000 to 2003 and 2007 to 2009, the S&P 500 halved in value. Someone running a portfolio with 50% borrowed money would have been wiped out.
In theory there is nothing wrong with borrowing a modest amount to buy more stocks, as we do to buy our homes. Even, say, borrowing an extra 10% or 20% could add materially to long term returns. But only if you are sure you can ride out the volatility. Otherwise you will end up losing, not winning, from the trade.
A margin account can also allow you to borrow against your marginable securities you already own. For example, if you have $3,000 in marginable stocks and haven't borrowed against them yet, you can buy other investments worth $3,000 without having to add any cash into your account. The marginable securities you already own act as collateral for the first 50% ($1,500), while the newly purchased marginable investments provide collateral for the other 50% ($1,500). So you'd now have $6,000 worth of stock in your account with a 50% loan value.
A margin loan allows you to borrow against the securities you own in your brokerage account. Buying on a margin increases your buying power since you can purchase more investments than you could otherwise buy using cash. While margin can increase your potential returns, it can also magnify your losses. Plus, even if you're right with your trades, interest charges can eat up your profits.
The money or securities in your account are collateral for the money you have borrowed. This collateral is called your margin. When you sell the securities bought on margin the broker will deduct the loaned amount, along with interest and any fees involved.
Many people borrow money to buy stocks without even knowing it. If you have an active loan and you choose to invest money rather than make extra loan payments, you are effectively using borrowed money to buy stocks.
That reluctance to endorse buying stock with borrowed money is often seen as hypocritical. Many of the fund managers and investment professionals that discourage individual investors from buying stock with borrowed money are managing highly leveraged portfolios. Warren Buffet, who has warned about the risks of leverage, used borrowed money to invest early in his career.
Warren Buffett has spent most of his lifetime making money on equity investments. You would think after decades of success, he'd have the confidence to buy stocks with borrowed money. After all, investing with borrowed money is a common strategy for amplifying gains.
And yet Buffett, one of the world's most successful investors, says borrowing to invest is a risk he's not willing to take -- not even when the market's down and the buying opportunities are plentiful. Here are the basics of investing with debt and why Buffett thinks it's such a bad idea.
If a down market pushes your equity value below the maintenance margin requirement, you must deposit money or sell assets to restore your equity cushion. This is the dreaded margin call. If you don't comply, your broker will sell your stocks to get your account back in compliance.
In Buffett's view, the upside of borrowing to invest isn't worth the risk. His concern is the potential for stocks to drop dramatically without warning. This is tough enough on investors who can choose to ride out the downturn.
The dormant but catastrophic risks associated with using large amounts of borrowed money to buy stocks or other financial assets were on full display in the financial crisis of 2008-2009. Financial services giant Lehman Brothers actually went bankrupt in September 2008 and the cause of death was leverage.
"The decision to invest with borrowed money comes down to comparing the cost of borrowing versus the expected investment returns," said S. Michael Sury, lecturer of finance at the University of Texas at Austin. "If the returns exceed the cost, then the transaction makes economic sense."
In a 2010 letter to Berkshire Hathaway shareholders, Buffett acknowledged some people had become "very rich through the use of borrowed money," while others had also become very poor. "When leverage works, it magnifies your gains ... but leverage is addictive," Buffett wrote. "Once having profited from its wonders, very few people retreat to more conservative practices."
The same scenario can occur on a consumer level. Say you've used $10,000 borrowed with a home-equity loan at 5 percent to purchase $10,000 in stock. That stock appreciates 10 percent, or $1,000, in a year. You paid $500 in borrowing costs and made $500 in profit that year. But if the stock lost 10 percent, you actually lost $1,500 instead of $1,000 had you paid in cash.
Whether an individual should borrow from one asset to invest in another seems to depend on their individual financial situation, age and goals, says Lyn Alden, founder of Lyn Alden Investment Strategy. Because there aren't many bargain stocks out there, she recommends taking advantage of low rates on student loan and consumer debt to pay down slowly while investing with cash savings.
Trading on margin means borrowing money from a brokerage firm in order to carry out trades. When trading on margin, investors first deposit cash that then serves as collateral for the loan and then pay ongoing interest payments on the money they borrow. This loan increases the buying power of investors, allowing them to buy a larger quantity of securities. The securities purchased automatically serve as collateral for the margin loan.
Buying stocks on margin means investors are borrowing money from their broker to purchase stock shares. The margin loan increases buying power, allowing investors to buy more shares than they would have been able to, using only their cash balance."}},"@type": "Question","name": "How Does Buying Stocks on Margin Work?","acceptedAnswer": "@type": "Answer","text": "To buy stocks on margin, a margin account must be opened and approval obtained for the loan. If the stock's price rises, the investor can sell the stock, repay the loan, and keep the profit. If the stock's price falls, the broker may issue a margin call, requiring more cash or selling the stock. The loan must be repaid regardless of whether the stock rises or falls.","@type": "Question","name": "Is Margin Trading Good for Beginners?","acceptedAnswer": "@type": "Answer","text": "Buying stocks on margin is not for beginner investors. It's important to understand the risks and that the margin loan doesn't exceed the investor's ability to repay the loan."]}]}] Investing Stocks Bonds Fixed Income Mutual Funds ETFs Options 401(k) Roth IRA Fundamental Analysis Technical Analysis Markets View All Simulator Login / Portfolio Trade Research My Games Leaderboard Economy Government Policy Monetary Policy Fiscal Policy View All Personal Finance Financial Literacy Retirement Budgeting Saving Taxes Home Ownership View All News Markets Companies Earnings Economy Crypto Personal Finance Government View All Reviews Best Online Brokers Best Life Insurance Companies Best CD Rates Best Savings Accounts Best Personal Loans Best Credit Repair Companies Best Mortgage Rates Best Auto Loan Rates Best Credit Cards View All Academy Investing for Beginners Trading for Beginners Become a Day Trader Technical Analysis All Investing Courses All Trading Courses View All TradeSearchSearchPlease fill out this field.SearchSearchPlease fill out this field.InvestingInvesting Stocks Bonds Fixed Income Mutual Funds ETFs Options 401(k) Roth IRA Fundamental Analysis Technical Analysis Markets View All SimulatorSimulator Login / Portfolio Trade Research My Games Leaderboard EconomyEconomy Government Policy Monetary Policy Fiscal Policy View All Personal FinancePersonal Finance Financial Literacy Retirement Budgeting Saving Taxes Home Ownership View All NewsNews Markets Companies Earnings Economy Crypto Personal Finance Government View All ReviewsReviews Best Online Brokers Best Life Insurance Companies Best CD Rates Best Savings Accounts Best Personal Loans Best Credit Repair Companies Best Mortgage Rates Best Auto Loan Rates Best Credit Cards View All AcademyAcademy Investing for Beginners Trading for Beginners Become a Day Trader Technical Analysis All Investing Courses All Trading Courses View All Financial Terms Newsletter About Us Follow Us Facebook Instagram LinkedIn TikTok Twitter YouTube Table of ContentsExpandTable of ContentsBuying Stocks on MarginExamplePotential RisksBuying Stocks on Margin FAQsTrading SkillsRisk ManagementWhy Is Buying Stocks on Margin Considered Risky?By 041b061a72