A margin loan or a margin account is a loan made by a brokerage house to a client that allows the customer to buy stocks on credit. The term margin itself refers to the difference between the market value of the shares purchased and the amount borrowed from the brokerage. Interest on the margin loan is usually calculated on the outstanding balance on a daily basis and charged to the margin account. As time goes by, the outstanding debt goes up and interest charges accumulate. Also, the brokerage holds the securities as collateral for the loan.
A simple example of a purchase on margin might be an investor buying stocks with a market value of $10,000 but only using $5,000 of their own money. The other $5,000 would be provided by the brokerage as a margin loan.
Sounds straightforward, but margin loans aren't simple.
If you want to trade on margin, the first thing you need to do is open a margin account. By law, this requires an initial investment of at least $2,000. But that amount could be more, depending on the brokerage house's own rules to open the account. This set up amount is known as the "minimum margin". Once your account is open, you can then borrow up to 50% of the price of any stock you want to purchase. Understand, you don't have to borrow the full 50%; the amount you borrow can be less than 50%. The 50% "down payment" is called your initial margin. As long as stock prices stay stable or go up and you make your interest payments your life will roll along smoothly.
However, you need to be aware of what is known as "maintenance margin", in case stock prices drop. According to the rules of the New York Stock Exchange (NYSE) anyone who buys stocks on margin must maintain a minimum of 25% of the total market value of the securities that are in the margin account. Some brokerages demand an even higher percentage.
Falling share prices could take your account below the minimum threshold and the brokerage house will require you to put in more cash or securities to bring your stake up to the minimum. The call from the brokerage demanding these incremental funds is known as a "margin call". Depending on the terms of the margin loan agreement you originally signed with the brokerage, they even may have the legal right to sell securities out of your account without consulting you, to get the back to the maintenance minimum.
Undoubtedly, margin accounts allow an investor to gain control of a large block of stock at a minimal investment. Sophisticated investors will use a margin loan to increase their personal wealth by using the "leverage" provided by using borrowed money.
However, if share prices go the wrong way, the investor with the margin loan, is not only liable for the money borrowed but also maintaining their margin account minimum. Now, leverage is working the other way and the falling share prices combined with the outstanding margin loan can cause an investor significant financial hardship.