A traditional lender such as a bank will not give you a loan so you can use the money to invest in the stock market. If the stock shares you buy with borrowed money go down, you might not be able to pay back the loan. The stock brokerage industry, working under the rules of the Securities and Exchange Commission, allows investors to borrow money to buy shares, with the stock acting as collateral for the loan.
Margin Brokerage Account
A margin loan is the type of loan a broker will provide to buy stock shares. To qualify for the loan, all you need to do is open a margin account with any stock brokerage firm. When you buy stocks in a margin account, if the cost of the shares is greater than the cash you have in the account, the broker provides a margin loan to pay the extra cost. With margin loans, you pay a portion of the cost of the shares and the margin loan covers the remaining part.
Borrowing Limits and Equity
Margin rules allow you to borrow up to 50 percent of the cost of the shares. This means if you want to buy $10,000 worth of stock, you need to have $5,000 of your own money in the account and the other $5,000 would be a margin loan. The $5,000 you put in is called your equity in the account. Margin account rules require a minimum of $2,000 of investor equity if a margin loan is outstanding. As a result, you need at least $2,000 to open an account. With that much money, you could buy up to $4,000 worth of stock.
If you have an outstanding margin loan, you must maintain at least 25 percent of your own equity in the account. You equity will fall if the stocks you own go down in value. Let's say you bought $10,000 worth of stock using $5,000 of equity. If the value of the shares dropped to $7,000, you would have $2,000 in equity with the $5,000 margin loan still outstanding. At this point, your equity level is $2,000 divided into $7,000, or 28.6 percent. Drop below the 25 percent minimum and your broker will require you to add more cash to the account or sell some shares and use the money to pay down the margin loan.
Paying Back Margin Loans
As long as your account equity stays above 25 percent, there is no requirement to make payments or pay off a brokerage margin loan. If your stocks go up or you add cash to the account, you can buy more shares and increase the size of the loan. Your broker will charge interest on the loan, which will be added to the outstanding loan balance. You can choose to pay down the loan at any time, using the cash in your brokerage account. A cash balance can come from stock dividends, selling shares or making a deposit.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.