Someone who wants to buy stocks that he or she can't completely fund might be able to get the money that is needed by borrowing it from the stockbroker. This type of loan is called a margin loan, and like most loans, it has an interest rate attached to it. The interest rate of a particular loan is determined by the individual broker, but it generally is based on the broker's call — also known as the broker's call rate or call loan rate. This rate is published daily in certain financial publications.
Greater Purchasing Power
Although a stockbroker might not be the first person an investor thinks of when he or she needs to borrow money, it can be a profitable venture. It is not an endeavor without risk, however. By signing up for a margin account with a stockbroker, the investor is able to purchase more stock than he or she otherwise would.
Equity Usually Required
The cash and/or stocks in the investor's account are used as security for the loan, and brokers usually impose a minimum equity percentage before an investor is eligible for a margin loan. This means that the value of the stocks owned minus the amount owed must be at least a certain of the total value of the stocks. In other words, the investor can't owe the broker more than a certain percentage of the value of the stocks — usually between 25 percent and 40 percent. If the value of the stocks drops and causes the investor's equity to fall below the broker's minimum, the broker might issue what is known as a margin call, which means that the investor must pay enough to raise his or her equity above the required minimum percentage.
The interest rate that the broker charges can be higher or lower than the broker's call rate. It generally is within 1-2 percentage points, but the difference can be greater. The broker's call is a variable rate, which means that it can fluctuate up and down based on the underlying interest rate index — the prime rate set by the government. A broker's call rate might vary during the life of the loan, or it might remain the same. The loan could be a long-term loan or a short-term loan.
Investors are advised to be careful when engaging in this sort of arrangement. If the stocks suddenly drop in value and the broker issues a margin call but the investor cannot or does not pay the required amount, the stockbroker can sell stock from the investor's account until the loan is repaid. This can be bad for the investor because that usually is the worst time for the investor to be selling that stock. If the investor cannot pay the required amount, however, there there is no other choice. Therein lies the risk of margin loans.
Other Funding Options
An investor who is thinking of using a margin loan when investing might be wiser to get a loan from a traditional bank, although the bank's interest rate often will be higher than the broker's call rate. This is partly because the bank will provide a fixed rate rather than a variable rate, as in the case of a broker's call. An investor should proceed carefully after weighing the risks of going with a margin loan versus all other loan options.