Should you buy a stock using a margin loan? Learn what can happen and some actions you can take to mitigate, but not eliminate, the significant losses that can occur when using a margin loan.
A Margin Loan Can Be Called at Any Time
A margin loan isn’t like a bank loan. Brokers can call in their loans at any time and expect an immediate payment, because it is in the margin account agreement. They don’t care about creditworthiness or whether you have enough non-liquid collateral to give them if something happens. Brokers expect payment immediately if they ask for it, because they also have financial obligations to meet. There doesn’t need to be a reason given for a margin call. A brokerage could change its mind about your loan. It might have experienced some financial trouble and might want to shore up its balance sheet, or someone might just have a bad feeling about the market and might want to be prepared. The brokerage could be calling in all margin loans to reduce risk for its shareholders.
Buying Stocks on Margin Is a Real Debt
Margin debt balances are real debt. They are every bit as real as going to the bank and signing for a mortgage, swiping a credit card, or taking out a student loan. Due to the ease with which new margin loans can be created under ordinary circumstances, investors sometimes fail to treat these liabilities with the respect they deserve. This risk of loan recall means you should always have the cash to pay the entire worst-case scenario balance in full. Have the money immediately available, sitting in the bank.
Companies Go Bankrupt
Companies go bankrupt or experience permanent capital impairment from time to time. Many investors not only put irresponsible amounts of capital in “booming” businesses thinking they were going to get rich, but sometimes they pile on call options and purchase common stock on margin to do so. As an example, suppose you took out a margin loan of $10,000 and purchased common stocks from a tech company that’s been performing great for the last two years, thinking it was about to erupt. You decided to purchase $5,000 in call options and didn’t have enough, so you also took it out on your margin account. Two weeks after your purchase, the company is caught falsifying its financial information. A massive sell-off of the stock takes place, your $10,000 investment is worth nothing, and your broker decides to call in margin loans. You owe $15,000 immediately. You have no money saved up to make a payment, so you’ll need to take out a loan to repay your broker. You have no collateral to put up for the loan, so your bank gives you a 10.5% interest rate for a 48-month loan. If you keep your payments current, you’ll end up paying close to $18,500 with interest.
Marketplace Panic
There will always be market panics, displacements, volatility, and shocks that affect the market. Many investors do not have a disciplined approach to investing, so they end up following the investing herd and incurring significant losses when the market shows a possibility of a downturn. When markets turn downward, investors begin to panic and sell to mitigate their losses. The market continues to decline as prophecies self-fulfill, and a market panic ensues. While you may not be panicking like the rest of the investing herd, you might experience a margin call that could drain your reserves or put you in debt if you haven’t planned for it.
No Way to Sell or Catch Prices Mid-Drop
Novice investors often make the mistake of thinking that for a stock to fall from $100 per share to $20 a share, it had to make multiple stops between $99 and $21 along the way. Unfortunately, prices can immediately move from Point A to Point E without ever hitting B, C or D. Worse, after a drop to new lows, the stock market could close entirely, so you might not be able to sell any of your holdings to meet a margin call. You’ll have to cover it all by wiring money or assuming a loan from your bank to the broker on demand.
Dividend Income Might Lead to Higher Taxes
Imagine you buy $100,000 worth of Royal Dutch Shell shares on margin. You should collect around $6,500 per annum in dividend income if the shares return 6.5%. Had you bought the stock outright, those dividends would have been counted as “qualified dividends,” which means you’d pay significantly lower capital gains tax rates, typically ranging from 0% to 20%. Instead, there’s a good chance that your broker will take the stock you’ve purchased on margin and lend it out to short-sellers. You’ll never know about it or even notice that it happened. The broker will pocket additional income for itself. When the dividend is paid on the stock, you don’t technically own it, even though it looks like you do in the brokerage account. Instead, you might be given a “payment in lieu of dividends” equal to the dividends you should have received. Payments in lieu of dividends are taxed at your ordinary income tax rate, which can be nearly twice as high. You’d receive your $6,500 and have to add it to your annual income. It might be enough to bump you into the next tax bracket and increase your taxes rather than giving you an additional $6,500 to reinvest.
Can You Use Brokerage Margin Debt?
One good rule of thumb for the margin balance of an account is to never exceed 5% of the market value for a loan—and even then, only use it for short-term cash flow needs; i.e., you are depositing additional funds in a few days but want to make a purchase today. A better alternative could be a negotiated line of credit (LOC) with your local bank. With a line of credit, you can tap the funds at your discretion and pay them back on a schedule rather than draining your account immediately. Another option is to segregate your U.S. Treasury bill holdings into your margin-authorized account, keeping your stocks and other holdings in the non-margin account. Then, you might tap into as much as 30% of the market value of your Treasury reserves. There’s still a risk of loss, but considering what can happen with a margin loan, it is much less.
