A Margin Account is a type of brokerage account that allows an investor to borrow money to buy securities, by borrowing a portion of the purchase amount from their broker-dealer.
Borrowing money to purchase securities is called “buying on margin.” Like other types of borrowing, interest is charged on margin loans, at a rate determined by the broker-dealer.
The margin is the amount the investor must personally provide as collateral for the loan, from either securities or funds on deposit.
Margin Accounts must maintain a certain level of equity or margin in their accounts at all times. This level of equity or margin is the difference between the value of the securities held as collateral in the Margin Account and the loan amount outstanding.
Setting Up A Margin Account
Margin Accounts requires approval by your broker-dealer, through whom a request for the account is made. An agreement is entered into between the client and the broker-dealer that spells out the terms under which credit will be extended and creates a lien against the collateral held in the Margin Account.
Margin rates vary by security, and (in Canada) minimum requirements are set by the Investment Industry Regulatory Organization of Canada (IROC). However, broker-dealers may have additional and more stringent margin requirements, including reserving the right to add even more stringent margin requirements at any time without prior notice.
The Risks of Using A Margin Account to Purchase Securities
Borrowing on margin is not appropriate for everyone and comes with a number of risks. The following are a few of them.
1. A Margin Call due to a decline in the value of securities held as collateral
If the value of your securities in your Margin Account declines in value, even for a brief period, the value of your collateral supporting the margin loan also goes down. This results in a ‘margin call’ where you are required to restore margin to your account, by:
- depositing additional cash or margin-eligible securities to make up the shortfall;
- selling sufficient other securities to make up the shortfall; and/or
- buying back short positions sufficient to make up the shortfall.
2. Your securities or assets can be sold without contacting you
If a ‘margin call’ is made on your account due to a margin deficiency, your broker-dealer has the right to sell or buy back all or a portion of any securities held in your account. The broker-dealer is not required to contact you (although they may) before taking action to restore margin to your account.
This may mean that securities or other assets you don’t want sold are sold. When your broker-dealer is restoring margin to your account time is of the essence and their first concern will be protecting their interests.
When securities or other assets are sold to restore margin you are usually charged full brokerage/commission fees.
3. Your Margin Agreement may allow for margin rules to be changed without notice to you
Most brokers-dealers will include in their agreement that the margin rules can be changed without notice. In the event a change is made to the margin rules, for whatever reason, you may find yourself facing a margin call and thus #1 and #2 above could apply to you.
4. You can lose more than you deposited into your Margin Account
When you purchase securities on margin, if a stock drops in value rather than increases, you may end up owing more than the original amount borrowed. Your original $5,000 loan might end up being a $7,000 loan, if your stocks don’t perform as well as you hoped.