Guidelines for Using Margin

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Guidelines for Using Margin

If margin can help you stay invested in the markets, some people may be tempted to use margin to invest more in the markets. Under current margin rules you can withdraw 50% of your account’s value in borrowed cash, but you can purchase securities on borrowed money worth 100% of your account’s value.

Imagine your investment account contains securities worth $100,000. You can borrow an additional $100,000 and purchase securities. Then you will have $200,000 in appreciating securities and $100,000 of margin loan that you owe. You will still be just under the limit of having the margin loan be less than 50% of the account value.

If the market appreciates 10% your account value will appreciate to $220,000. Your $100,000 of equity will have made a 20% gain after paying back the $100,000 margin loan. Conversely, if the market depreciates by 10% your account value will drop to $180,000. Your $100,000 of equity will have lost 20%. You will also experience what is called a margin call since you are now over the limit of 50% of the account value. A margin call would require you to put $20,000 more into the account to bring your loan back under the 50% limit.

Taken to the extremes, if your stocks go up by 50% you can double your money. And if stocks go down by 50% you will have lost everything. In either case you will also owe margin interest for the money you have borrowed.

Buying an asset for a little bit down and taking a loan for the rest is called leveraging. Leveraging amplifies gains and losses. The most common form of leveraging for most investors is when they buy their principle residence and take out a 30-year mortgage. We recommend leveraging for buying your principle residence.

Imagine you have the $240,000 necessary to purchase your first home. Now you have the choice of either purchasing the house outright or putting a $40,000 down payment on the house and getting a 30-year fixed mortgage at 3.5% to finance the remainder.

In this case being debt free and avoiding a mortgage is very comforting but not usually the savviest financial decision.

If you get a mortgage, you can keep the $200,000 invested in the stock market. At 3.5% amortized over 30 years your monthly payment would be $898.09 and you would ultimately pay $323,312 for your home, $123,312 of which is interest which you can deduct on your taxes.

Meanwhile you can invest the $200,000 and let it grow in the stock market.

Even if your returns in the stock market only average 7% over the next 30 years, your investments double about every decade.  Your $200,000 would grow to $1.5 million. You may also owe capital gains tax on the growth, but what a nice problem to have!

We’ve run the numbers for many different mortgage scenarios, and it is nearly always better to have a mortgage. The best results come from a 30-year fixed mortgage where you have not paid any closing costs,  not bought down the interest rate by paying points, but do keep the money you would have paid to purchase the house invested in the markets.

Seeing how leveraging works for a personal mortgage, you may be wondering why we don’t recommend it for borrowing money to invest in the stock market.

In short, we don’t recommend going on margin to buy more stocks because it is too risky.

With a mortgage, you have a fixed interest rate for 30-years, there are no margin calls if the price of your home drops, and you are using a relatively stable asset to finance a very volatile asset.

With margin, you have a variable rate which can rise suddenly, you could experience a sudden margin call where you have to come up with large amounts of cash quickly, and you are putting all your eggs in one rollercoaster ride.

The stock market is risky enough. Amplifying stock returns can both increase the average return and increase your chance of failure. This may seem paradoxical, but a simple example illustrates how.

Imagine a game in which you have a 50-50 chance of either making 30% or losing 10% each turn. On average your investments would go up by about 10% each turn. You would never be in danger of losing everything and being kicked out of the game.

Now imaging amplifying the returns ten-fold. Each turn you have a 50-50 chance of either making 300% or losing 100%. Your average return is now 100%. But if you have a single unfortunate turn you lose everything and have nothing for the next turn.

Too much leverage is risky because it endangers meeting your goals.

Another observation should be made to warn against too much leverage. Many real estate millionaires go bankrupt because they leverage purchasing dozens of properties only to have the housing market drop suddenly. Real estate leverage can make or lose a great deal of money quickly when housing prices rise or fall. Leveraging your principle residence is relatively safe. Leveraging an entire neighborhood is very risky.

Photo used here under Flickr Creative Commons.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818…)

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