What Is Buying on Margin and How Does It Work?

Buying on margin allows investors to acquire securities by utilizing funds borrowed from a brokerage firm. This practice essentially involves taking out a loan, with the purchased securities often serving as collateral for the borrowed amount. The primary purpose of engaging in margin trading is to expand an investor’s potential buying power beyond their available cash.

What is Buying on Margin?

Buying on margin involves an investor borrowing money from a brokerage firm to purchase securities. This arrangement requires a specific type of brokerage account known as a “margin account,” which differs from a standard “cash account” where an investor must pay the full amount for securities purchased. Unlike a cash account, a margin account grants the ability to borrow funds from the broker to facilitate transactions.

The securities acquired through margin are held in the account and function as collateral for the loan. The collateral arrangement means that the investor’s existing securities, along with those purchased with borrowed funds, secure the loan from the brokerage. In essence, the brokerage extends credit to the investor, and in return, the investor pledges assets within their account. This allows investors to increase their exposure to the market by leveraging their current holdings.

Mechanics of Margin Trading

The brokerage firm extends this credit, and the investor’s cash and securities in the account serve as collateral for the loan. This loan accrues interest, which is typically calculated daily and charged against the account monthly. The interest rate on margin loans can vary among brokerage firms and often fluctuates based on market conditions.

An investor’s buying power is significantly increased when using margin. For example, if an investor has $5,000 in their account and the initial margin requirement is 50%, they can purchase up to $10,000 worth of securities. This means the investor contributes $5,000 of their own capital, and the brokerage lends the remaining $5,000. The ability to buy more securities than one could with cash alone is a central feature of margin trading. The borrowed amount is repaid, often with proceeds from selling the securities, with the loan being paid off first.

Essential Margin Terminology

“Initial margin” refers to the percentage of the purchase price of securities an investor must pay with their own cash. The Federal Reserve Board’s Regulation T generally sets this initial requirement at 50% for most equity securities. This means that for a $10,000 security purchase, an investor typically needs to provide at least $5,000 from their own funds.

“Maintenance margin” is the minimum percentage of equity an investor must maintain in their margin account after a purchase. Equity is calculated as the value of the securities minus the amount owed to the brokerage firm. The Financial Industry Regulatory Authority (FINRA) mandates a minimum maintenance margin of 25% of the total market value of securities purchased on margin. Many brokerage firms establish higher maintenance requirements, often ranging from 30% to 40% or more.

A “margin call” occurs when the equity in an investor’s margin account falls below the required maintenance margin. This is a demand from the brokerage firm for the investor to deposit additional funds or securities to bring the account back to the required equity level. If an investor fails to meet a margin call, the brokerage firm may sell securities in the account to cover the deficiency, sometimes without prior notification.

“Marginable securities” are those assets that can be purchased using borrowed funds in a margin account. Not all securities are eligible for margin trading; generally, those with high liquidity and trading on major U.S. exchanges, such as most stocks, bonds, and exchange-traded funds (ETFs), are considered marginable. Securities like penny stocks or those from initial public offerings (IPOs) are often not marginable due to their higher risk profiles or lower liquidity.

Regulation of Margin Trading

The Federal Reserve Board plays a role in this by issuing Regulation T (Reg T), which governs the extension of credit by brokers and dealers for securities transactions. Reg T primarily sets the initial margin requirements, stipulating that investors can borrow up to 50% of the purchase price for marginable equity securities. The Financial Industry Regulatory Authority (FINRA) also establishes important rules for margin trading, particularly concerning maintenance margin requirements and other operational aspects for brokerage firms. FINRA Rule 4210, for instance, sets the minimum maintenance margin for equity securities at 25% of their current market value. This rule also includes initial margin requirements for securities not specifically covered by Reg T, such as corporate bonds.

Beyond these federal and industry-wide regulations, individual brokerage firms often implement their own “house requirements” for margin accounts. These firm-specific requirements must be equal to or stricter than the minimums set by the Federal Reserve and FINRA. Brokerages may impose higher initial or maintenance margin requirements based on factors such as a security’s volatility, liquidity, or the concentration of an investor’s account. These house requirements can change at any time, potentially without advance written notice to the investor.