Any investor who dips a toe in the stock market to secure a comfortable retirement or acquire the equity needed to buy a house should know that there are a few wrinkles in this plan, not the least of which is the investor's buying power. That buying power is equivalent to the money in your cash account with your broker and the loan value of the securities held in your margin account. The types of securities in your account and their values determine the amount your broker allows you to borrow.
Cash Account vs. the Margin Account
An investor makes decisions about her buying power when she opens a brokerage account. For instance, you must decide whether you want a cash account or a margin account or both.
With the cash account, your buying power is limited by the cash you deposit in that account. A margin account, on the other hand, extends you a line of credit by leveraging the value of the securities in that account. This line of credit allows you to buy more securities than you could if limited by the cash you have on hand.
Read More: What Is Margin Selling?
How a Cash Account Works
As an investor, you use the cash in your cash account to purchase securities. For instance, once you deposit $10,000 in your cash account, you can purchase a total of $10,000 in securities (less trading fees, if applicable.) To buy more, you either make an additional cash deposit in the account or sell some investments.
When you use a cash account to finance your investments, your losses are limited by the dollar amount you deposit in your cash account. When you invest using $10,000 in your cash account, for example, your losses are limited to $10,000.
Read More: Requirements for Buying Stocks on Margin
How a Margin Account Works
To create a margin account, your brokerage firm extends you a line of credit by leveraging your the values of the securities you own. You use this line of credit to buy more securities than you could if limited by the cash in your cash account.
While the margin account grants you flexibility in terms of the dollars you can invest, it also increases the risk of a stock you purchase using the margin account. In this case, if the market price of the security you buy falls, your financial loss includes the cash you used to purchase it plus the cash you borrowed using your margin account. What's more, that loss will include the interest your brokerage firm charges on your margin account loan.
Read More: How to Calculate an Initial Margin Requirement
Margin Interest Rates
When buying securities using a margin account, you must select stocks that will grow faster and to a greater degree than will margin interest costs. For instance, assume that you pay an annual percentage rate of 10 percent on a loan you receive by means of margin account. To break even, your investment must increase by 10 percent. To realize a net gain, your investment must increase in value by more than 10 percent.
Also, keep in mind that one firm's margin rate will vary from that of another. Typically, the rate is three or four percent higher than, say a home equity line of credit.
Margin Loan Repayment Schedule
Margin loans generally have no set repayment schedule. You can repay your loan at any time, although you will continue to accrue monthly interest charges until your loan is repaid. What's more, the securities in a margin account will serve as collateral for your margin loan. If the price of a stock holding increases to $30,000 and you sell it, your profit is the difference between its sale price plus the margin loan amount plus interest.
The requirements that govern margin accounts include those set by the SEC, FINRA, your brokerage and other organizations.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.