Borrowing money -- using credit -- to buy stocks allows you to leverage the gains from the stocks you buy. However, leverage is dangerous to an investor's net worth if the stocks go down in value. The Securities and Exchange Commission has set up a system which brokers use to offer credit to buy stocks. This system is referred to buying stocks on margin or buying through a margin account.
Brokerage Margin Accounts
Any investor can apply for and obtain a margin brokerage account. The only requirement is to maintain the minimum level of equity -- investor's money -- required by the broker and SEC rules. When stocks are purchased, a margin loan can be used to pay for a portion of the stock purchase. Brokers charge an attractive rate of interest on margin loans. Margin loans do not require regular payments and do not even need to be repaid as long as the account meets the investor equity requirements.
Margin Loan Limits
Margin rules allow an investor to borrow up to 50 percent of the cost of stocks using a margin loan. Or, from the other side, margin loans allow an investor to buy twice as much stock as she has available equity. For example, if a margin account has $10,000 in cash, the investor could buy up to $20,000 worth of stock. If the investor initially buys $15,000 of stock, the account would have a $5,000 margin loan after the stock purchase. If the $15,000 worth of stock increases to $20,000, the account would have $15,000 worth of equity and a $5,000 outstanding margin loan -- a 50 percent gain on the equity invested. With the larger amount of equity, the investor could buy $10,000 more stock, bringing the margin loan up to $15,000 and total account value to $30,000.
Securities and Exchange Commission rules require an investor maintain a minimum equity of 25 percent $2,000 which ever is greater. A broker may set higher limits for its margin account customers' margin equity. An investor's equity declines when the stock owned falls in value. If an investor purchased $30,000 worth of stock with $15,000 of initial equity and the value of the stock declined to $20,000, the investor's equity would be $5000 -- $20,000 minus the $15,000 margin loan -- or 25 percent of the account value. If the stocks declined further, the investor would receive a margin call from the broker to add more cash or sell stocks to pay off a portion of the margin loan.
The margin agreement for a margin account gives the broker the right to sell securities out of a margin account if the investor does not maintain the required level of equity. Margin calls are serious business and an investor who receives the notice should quickly take care of the issue by either adding more money to the account or selling stock to pay down the loan. A better plan is to keep a close eye on the equity level and not let a margin account get to the margin call point. Calculating the available margin can be complicated. Most brokerage accounts will list the available buying power for an account. This is the amount of stock you could buy with the current equity level in your account. If the equity is less than 50 percent, there will be zero buying power available.
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.