Margin debt is money a stock market investor borrows to invest in stock. Borrowing part of the purchase price, or buying on the margin, can improve the realized returns of a stock investment. Before opening a margin account and using it to purchase stock, an investor should understand the restrictions and risks involved with using margin debt.
An investor can get a margin loan to buy stock by applying for a margin account with a stock broker. There is no additional collateral required for with margin debt besides the stock purchased. When an investor buys stock in a margin account the broker will lend the money to pay for a portion of the stock purchase. The amount an investor can borrow is based on the amount of equity, stocks and cash, the investor has in the account.
An investor can borrow up to 50 percent of the purchase price of stock using margin debt. An investor with $5,000 could buy $10,000 worth of a stock and half of the purchase price would be margin debt. The initial margin debt level applies to the total value of an investor's account. If the investor made an initial deposit of $10,000 into a margin account, he would have $20,000 worth of stock buying power. He could buy several different stocks until the total spent on stocks was the $20,000. At that time, the investor would have $10,000 in equity and $10,000 of margin debt.
Margin debt does not have to be paid off as long as the investor keeps an adequate level of equity in the account. However, the broker does charge interest on margin debt and the interest owed will accrue to the loan balance. The investor who buys on the margin needs to have the stocks increase in value at a rate at least equal to the interest rate on margin debt.
The stocks held in a margin account are the collateral for the margin debt. Margin rules limit how low the investor's equity can fall before he is required to add more money or sell some stock. The maintenance margin level is 25 percent investor equity. For example, our investor bought $20,000 worth of stock with $10,000 in equity and $10,000 in margin debt. The value of the stock has fallen to $12,000. The account now has $10,000 in margin debt and just $2,000 in equity, or 16.6 percent equity. The investor would have to add cash to bring the equity up to 25 percent or sell some stock to reduce the size of the margin loan.
Using margin debt magnifies the gains or losses in an investor's stock account. In the margin maintenance example above, the value of the stock fell by 40 percent, but the investor had lost 80 percent of his equity. If the stock portfolio had grown to $25,000, the investor would have a $5,000 gain on his $10,000 investment or a 50 percent profit even though the stock went up just 25 percent.
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