Is Common Stock Considered a Form of Credit?

Common stock is a core component of financial markets, though its relationship with credit is often misunderstood. This article clarifies what common stock is, how it differs from credit, and how it can indirectly interact with borrowing. Understanding these distinctions is important for investors and those managing personal finance.

What Common Stock Represents

Common stock signifies an ownership stake in a corporation. When an individual purchases shares, they become a part-owner of that company. This form of ownership is classified as equity, representing a residual claim on the company’s assets and earnings after all liabilities are satisfied.

As owners, common stockholders possess rights, such as voting on corporate matters, including electing the board of directors and approving policy changes. They can benefit from the company’s success through capital appreciation and dividends, which are distributions of a company’s profits. Unlike creditors, common shareholders do not receive fixed payments; their returns are directly tied to the company’s performance and profitability.

Common Stock Is Not Credit

Common stock differs from credit or debt instruments. Credit involves a direct lender-borrower relationship, where funds are provided with an expectation of repayment, usually with interest, by a specified date. Examples include bonds (loans to a company or government) and various personal or business loans. Creditors hold a legal claim to repayment, and their terms are fixed.

Common stock, by contrast, does not entail a promise of repayment from the issuing company. Investors buy shares on the open market; the company does not owe them their initial investment back. Instead, the investment’s value fluctuates with the company’s performance and market conditions. In liquidation or bankruptcy, common stockholders are last in line to receive any remaining assets, paid only after all creditors (including bondholders) and preferred stockholders. This demonstrates common stock represents a riskier ownership position rather than a secured lending arrangement.

Leveraging Common Stock for Credit

While common stock itself is not credit, it can serve as an asset to obtain credit. Shares can be used as collateral to secure various types of loans or lines of credit. This means the stock’s market value acts as security for borrowed funds, providing lenders a claim on the asset if the borrower defaults.

Two common ways to leverage common stock for credit are through margin loans and securities-backed lines of credit (SBLOCs). A margin loan, offered by brokerage firms, allows investors to borrow using eligible securities as collateral, typically to purchase more securities. An SBLOC is a revolving line of credit that also uses securities as collateral, but the funds can be used for a wider range of purposes, often at competitive interest rates. Lenders allow borrowing up to a certain percentage of the collateral’s value, often ranging from 50% to 95%, depending on the securities and lender’s policies.

A significant risk when using stock as collateral is the potential for a margin call. If the collateralized stock’s market value declines significantly, the lender may require the borrower to deposit additional funds or securities to maintain the required equity. Failure to meet a margin call can result in the forced sale of pledged securities by the lender to cover the loan, potentially at a loss to the borrower. While common stock can facilitate access to credit, it carries inherent risks when used in this manner.