Margin is borrowed money from a brokerage firm that an investor can use to buy more stocks. Investors who buy stocks on margin incur borrowing costs, which accumulate each day that the margin loan is outstanding. Like any borrowing to invest, it can magnify profits if the stock price rises, or exacerbate losses if the price declines.
In exchange for the loan, an investor pays the broker interest on the margin loan as well as pledges the purchased shares as collateral. It’s necessary to calculate the rate of the loan, or margin loan interest, to get the true “cost” an investor is paying. That’s because a stock would have to rise by more than that margin loan interest in order for the investor to make money from that trade.
How is margin interest calculated?
Margin loan interest rates are quoted on an annualized basis. Let’s say an investor has $25,000 and borrows another $25,000 to buy $50,000 of XYZ Corp. shares. The broker they borrow from charges a 7% rate. The investor’s annual interest cost on the $25,000 loan would be:
$25,000 X .07 = $1,750
However, most investors borrow for only part of a year. And because interest accrues daily, the investor should know the daily interest cost of the margin loan. The formula for that is simple:
(Loan principal X interest rate) / days in the year
Most brokerages use 360 days for the year—or an average of 30 days for each month—not 365 days. It’s a small difference, but it does bump up the interest cost slightly.
For the example above, the daily interest calculation is:
($25,000 X .07) / 360 = $4.86
So for each day the investor has the $25,000 margin loan, at 7%, the borrowing cost is $4.86.
Let’s say the investor sells the XYZ stock position 30 days later, and repays the loan. The total interest cost of the margin loan based on the number of days would be:
$4.86 X 30 = $145.80
At the end of each month, the daily accrued interest on the loan is tallied and deducted from an investor’s account.
Rates for margin loans
Broker rates for margin loans vary, from a low of about 2.5-3% for institutional investors with more money to trade, to as high as 10% for small investors. The higher rate is one way brokers make up for offering low-commission or commission-free trades. The rate an investor obtains may depend on several things including:
- Prevailing interest rates. The short-term federal funds rate, which is set by the Federal Reserve, is typically used.
- Broker call rate. This is the rate a broker pays its own lender for funds to be used in granting margin loans.
- Account size. The amount of money an investor has in the brokerage account; the more money, the lower the rate.
- Type of brokerage. Some firms may rely more on margin loan revenue and demand higher rates; others may rely less, instead charging investors for other services.
- Market volatility. During times of financial market volatility, brokers generally charge a higher rate.
Potential costs and risks of margin borrowing
The investor buying stocks on margin faces two potential challenges:
- Margin calls. If the value of the investment falls too low relative to the loan amount, a broker will notify the investor in what’s known as a margin call. The investor will then have to quickly put up more cash, or sell some of the purchased shares, to ensure that the loan can be repaid. Furthermore, losses can mount quickly if the broker starts selling the margin stock position to repay the loan.
- Interest costs. Even if the stock price rises, the interest cost could diminish or erase gains from trading the stock. For example, if an investor is paying 7% annualized interest, the purchased shares would have to rise more than 7% annualized before the investor has a profit. In other words, the investor must clear a 7% hurdle before trading on margin can be profitable.
To determine a breakeven stock price needed to justify the borrowing cost, let’s return to the XYZ example. If we assume the investor paid $250 a share, then 100 shares were bought for a total of $25,000. Then add the 30-day interest cost to the $25,000 principal:
$145.80 + $25,000 = $25,145.80
Then divide the total by 100 shares:
$25,145.80 / 100 = $251.458, or $251.46 rounded to nearest cent
So, if the investor sells XYZ shares 30 days after buying them on margin for $250, the selling price would need to exceed $251.46 a share for the investor to have a net gain after interest costs of the margin loan.
Potential benefits of using a margin account
Using a margin account could offer investors a number of possible benefits, including:
- Leverage. Using borrowed money, known as leverage in finance, helps an investor to take better advantage of bull markets because leverage magnifies gains. The challenge is in trying to time markets for bullish trends. Margin buying only works for investors in bull markets.
- Quicker access to funds. Investors normally must wait for three days after a stock sale to withdraw money. A margin account allows them to borrow for the three days while awaiting settlement of the stock sale. Investors might find it useful to have a margin account for this reason, even if the margin is never used to buy stocks.
Other types of margin
Margin can have different meanings outside of the stock market, and investors should be careful not to confuse them.
In the futures market, margin refers to a cash deposit made by an investor with the broker before buying or selling futures contracts. It is usually a small percentage, about 3% to 12%, of the futures contract value. Unlike stock margin, the deposit is not a loan, so there’s no interest cost.
In corporate accounting, margin refers to various profitability measures of a company’s business, such as gross margin, operating margin, and net margin. For example, a company with $10 million of sales and operating profit (which is sales minus the cost of goods sold and administrative expenses) of $3 million would have an operating margin of 30%:
$3 million/$10 million = 0.3 or 30%
The bottom line
Buying stocks on margin can amplify profits if the share price rises, but it carries the risk of a margin call if stock prices fall. In these cases, investors are then required to either replenish the cash balance or sell some of the purchased stock, possibly at distressed prices, to repay the loan.
The secondary risk is that even if stock prices rise, the increase must exceed the interest rate on the margin loan for the investor to make a profit. Small investors generally face the highest margin-loan costs while fund managers and institutional investors pay margin rates that are less than half what small investors pay.