When you buy stock on margin, you borrow money from your broker. For example, you might buy $10,000 worth of stock by paying $5,000. You owe the borrowed portion to your broker plus interest. If your stock goes up in value, you get profits on the full $10,000, instead of just on your $5,000. If that stock pays dividends, you can still buy it, but you won’t collect the dividend until you sell the stock.
Where Dividends Go
As long as you hold the stock you bought on margin, the broker will hold any dividends that get paid to you. He will apply this money toward the debt you owe him, but not until you actually sell the stock. If you sell the stock for a profit, you can pay back the broker what you borrowed and collect your dividends.
If you find a stock that pays exceptionally high dividends, such as some penny stocks do, you may think you found a way to pay for the interest your broker charges on the borrowed money and still see a profit. However, brokers do not allow margin investing on just any stock. You have to check to see which ones are eligible. In practice, stocks that pay extremely high dividends may be too risky for brokers to loan money on. Brokers may see such companies as spending all of their money paying dividends instead of reinvesting for growth.
Stocks that pay a low dividend, such as in the range of 1 to 2 percent, may barely keep up with the interest rate the broker charges for the borrowed money. In fact, you could end up falling behind. This means you will need some growth in the share price of the stock to make a profit. The problem with this strategy is that dividend stocks typically do not grow as fast as non-dividend-paying stocks. You would have to look for a dividend stock that has a history of growing its share price.
If your share price drops below where you bought it, the broker may ask you to deposit more money. This is a margin call. For example, if you buy $10,000 worth of stock on margin and pay $5,000 for it, it could drop to $8,000 in value. That means you've lost $2,000 on your initial $5,000 investment. Even if your stock pays a dividend, the broker may ask you to make a deposit to make up for the loss. In this example, you have a 40 percent loss, because $2,000 is 40 percent of $5,000. No dividend rate will make up that difference.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.