We’ve discussed the risks of margin calls in previous blog posts. Many investors go into an arrangement for margin calls without completely understanding what they’re getting themselves into, only to discover they’ve lost money. While financial advisors frequently fail to properly explain the cost of buying on margin, wall street makes massive profits off of these loans. In a recent investor bulletin, the SEC discussed interest on margin loans for investors who use them.
How Margin Works
A margin account can potentially increase the amount that an investor can use to purchase securities, with the potential for increased returns or bigger losses. If the price of the security you purchased on margin decreases, you could lose more than you invested. You’ll then be required to put money into your account to cover the losses, known as a “margin call,” or your broker may just sell the securities to cover the losses. That’s why purchasing on margin is a much riskier form of investment.
When you invest on margin, your brokerage loans you the additional funds to purchase more of the stock or other securities, using the securities you have as collateral.
The Margin Loan
Of course, borrowing that money to increase your purchasing power comes with a price. In this case, broker-dealers charge interest on the money they loan you for the margin buys. This interest will decrease your return on investment and increases what your investment has to earn in order to reach the break-even point.
Interest rates differ between brokerages, so it’s important to find out what your brokerage charges before you agree to anything.
There are also two different ways brokerages handle interest charges with something known as “netting,” involving what’s in your cash account versus what’s in your margin account.
- A firm with a “netting policy” will not charge interest but will move funds from your cash account into your margin account to cover the amount of the margin loan.
- A firm that engages in “no netting” charges full interest on the margin loan, and the amount in your cash account will have no bearing on the margin account.
It’s important to understand your brokerage’s margin loan policies, and make sure it’s clearly explained to you before you move forward. Each brokerages policies are different, and the amounts charged will vary greatly.
Naturally, this loan doesn’t come without interest, and you should understand that part as well before investing. It’s one of the reasons some brokerages can offer low- or no-commission trades. This information should be available on their website or from your broker directly.
If you want to know how much interest you’ll be charged, you’ll need to
- Multiply the borrowed amount by the interest rate
- Divide the number by 360 for a year (not 365), to get a daily interest rate
- Multiply the daily rate by the number of days you’ll be borrowing that money
Note that you will owe the same amount of money whether you make money on a trade, or lose it. That interest is still part of the transaction. That’s why it’s important to understand not only the potential for loss or gain, but the entire actual cost of the transaction whatever the outcome.
The SEC bulletin also offers specific questions to ask your broker before you agree to a margin loan for purchasing securities. This includes asking for the interest rate and its variance, how often interest is charged, sweeping and netting practices. More information on margin accounts and margin calls are discussed on the SEC’s investor education page, Investor.gov.
Did Your Financial Advisor Recommend an Unsuitable Margin Loan?
If you’ve bought on margin, you’re encouraged to contact Silver Law Group for additional information and to help us in our investigation. Our securities and investment fraud attorneys can help you recover improper losses.
Silver Law Group is a nationally recognized securities arbitration and class action law firm representing victims of investment fraud. Our attorneys represent investors in class action lawsuits against issuers in state or federal court and investors in securities arbitration claims against Wall Street firms for stockbroker misconduct.
Scott Silver, Silver Law Group’s managing partner, is the chairman of the Securities and Financial Fraud Group of the American Association of Justice. Contact us for a consultation at email@example.com or toll free at (800) 975-4345.