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One form of credit typically available to investors is margin borrowing. When you borrow “on margin,” you borrow money from the brokerage firm that holds your investment securities, and in turn pledge the securities as collateral for the loan. Most exchange-traded stocks, mutual funds, and individual bonds can be borrowed against, but margin borrowing is prohibited for securities held in most tax-deferred retirement accounts such as IRAs.

Operating similarly to a line of credit, margin loans don’t have specific maturities or due dates, and there’s no required monthly payment for either principal or interest. The brokerage firm loans you money, and in turn, charges a floating interest rate which is based on the “broker’s call rate” (a rate that’s generally less than most other short-term interest rates, such as the prime rate) plus a spread.

How It Works in Practice

Let’s assume you hold stocks and stock mutual funds with a current market value of $100,000 in your brokerage account. You would like to purchase additional stocks, but don’t have cash on hand. The broker will lend you $100,000 so that you can purchase an additional $100,000 worth of stock. You now hold $200,000 of stocks at market value ($100,000 of which is your “equity,” and $100,000 of which is a margin loan). In this case, you’ve established an initial 50% margin position – the maximum margin limit allowed by the Federal Reserve Board.

1. So, what happens if your securities appreciate 30% in value to $260,000? Your margin loan is still $100,000, but now your equity position in the securities has risen to $160,000. Essentially, you’ve made a 60% return on a 30% appreciation in securities prices. This multiplier effect on your return is a consequence of the leverage employed and is one of the primary reasons why investors consider margin borrowing. But like any opportunity for increased return, it comes with increased risk.

2. What if instead your securities drop 30% in value to $140,000? You would still owe the $100,000 margin loan, so your $100,000 in equity absorbs all of the loss and is worth only $40,000 (a -60% return)! Furthermore, since your equity now represents only 28.6% of the market value for the securities, you’ll receive a “margin call” from your broker. Most brokerages set a minimum maintenance margin limit of 30% or 35%. This means you’ll be required to increase your equity by either 1) depositing more cash ($2,000, assuming a 30% minimum maintenance requirement) or securities into your account, or 2) selling some of your existing shares, with the sale proceeds used to reduce your margin loan. If you don’t do either within a few days, the firm will automatically sell some of your securities until the maintenance margin is reestablished, thus forcing you to sell in a declining market.

It’s important to note that margin borrowing doesn’t have to be used to purchase additional securities. Most brokerages will allow you to borrow against your securities and use the cash for personal needs. Given the comparatively low interest rate, this may be a preferable short-term liquidity solution to other available alternatives (e.g., home equity loans or 401k loans). The initial margin and maintenance margin limits still apply, however, and serve as a restriction on how much borrowed cash you can take out.

Establishing and Using a Margin Account

Margin loans are extremely easy to set up and use. You simply sign an agreement with your broker either when you establish your account, or it can be added later. There’s no cost to enable the feature, and no interest is incurred until you actually borrow. Furthermore, since your securities are held as collateral, there’s no detailed review of your financial situation. A margin loan is initiated by simply buying additional securities, or by withdrawing cash, in an amount exceeding your brokerage account’s available cash balance. Interest charges then begin to accrue immediately on the borrowed amount. Interestingly, unlike most other forms of credit, margin interest rates typically decline at specified dollar breakpoints as the loan size increases.

Margin loans are floating rate loans, but without any specific maturity or due date, or minimum monthly payments. Margin rates move in tandem with the broker’s call rate, which in turn is a short-term rate which reacts almost immediately to any change in policy of the Federal Reserve. If the Federal Reserve moves to either increase or decrease short term interest rates, you will see the same change the next day in your margin rate. However, you are not required to pay back your margin loan by a specific date, or pay any of the interest accruing on the loan by a certain point, provided the maintenance margin requirement is always satisfied.

Tax Deduction for Margin Interest

Although the Tax Cuts and Jobs Act (TCJA – effective in tax-year 2018) eliminated most miscellaneous itemized deductions, the investment interest deduction survived. And since margin interest is considered investment interest if it’s paid to either buy or hold securities, it may be taken as an itemized deduction for Federal and state income tax purposes. Even if you borrow and remove cash from your account for other purposes, the interest may still qualify as deductible if you can show that incurring the margin loan allowed you to continue to “hold” securities that you otherwise would have needed to sell to raise cash.

The interest deduction may be limited in a given year if the margin interest expense incurred exceeds the net taxable investment income from all sources for that year (investment income includes taxable interest income, non-qualified dividends, short-term capital gains, and short-term capital gains distributions). For example, if you incur $5,000 of margin interest expense, but have $6,000 of investment income, the full $5,000 margin interest may be deducted. If, however, you only had $4,000 of investment income, $1,000 of the margin interest would not be deductible. This problem can be addressed in one of two ways to restore the deduction. You may choose, in the current year, to recharacterize some long-term capital gains or long-term capital gains distributions as “short-term,” thus adding to your investment income amount. Although this may allow you to take the full deduction for the margin interest, the recharacterization also subjects that portion of your income to higher ordinary income tax rates rather than the lower long-term rates that would have applied. Alternatively, you can carry forward indefinitely to future years the unused deduction, in this case $1,000, and take the deduction against investment income in a later year. In all cases, any portion of margin interest attributable to tax-exempt securities (such as municipal bonds) held as collateral for the margin loan is not deductible, nor is any margin interest incurred to buy tax-exempt securities.

Strategies for Margin Borrowing

Margin borrowing can often serve as an extremely convenient and low-cost, tax deductible source of short-term cash. As described earlier, it’s exceedingly easy to establish margin borrowing privileges, and borrowing itself can be invoked or terminated by nothing more than just buying or selling a security in your account, writing a check against your account, or depositing cash back into it. Therefore, it can be an ideal source of funds when you expect to be able to replenish the borrowed cash soon, and don’t want to incur the commission and tax costs of liquidating, then repurchasing securities in your account.

If you have check writing privileges on your account, margin serves as a form of overdraft protection, ensuring that a check written exceeding your cash balance will still be honored, with the amount of the overdraft treated as a margin loan. It can also serve as a backup source of emergency cash rather than maintaining excess cash reserves in low interest-bearing cash equivalents.

Alternatively, when used as a long-term borrowing vehicle to obtain more leverage or market exposure in your investment portfolio, margin borrowing can be a powerful wealth generator. It also may also be used to extract money from investments you don’t want to sell (e.g., highly appreciated securities or a concentrated stock holding) in order to buy other securities and achieve greater portfolio diversification.

Whenever employing margin borrowing for long-term purposes, however, you should be confident that the expected incremental return on the investments you purchase on margin will exceed the cost of the margin interest, on an after-tax basis. You must also be prepared to assume the risks described earlier in the event of market drops, where multiplying losses combined with margin calls can create serious financial problems. It’s always a wise strategy to borrow less than margin limits allow, to help further reduce the possibility of a margin call amidst a severe market downturn.

For additional information on this or related topics, or to learn more about the investment management and financial planning services offered by Cerity Partners, please visit our website at ceritypartners.com.


Cerity Partners LLC (“Cerity Partners”) is an SEC-registered investment adviser with offices in California, Colorado, Illinois, Massachusetts, Michigan, New York, Ohio and Texas. Registration of an Investment Advisor does not imply any level of skill or training. The foregoing is limited to general information about Cerity Partners’ services, which may not be suitable for everyone. You should not construe the information contained herein as personalized investment, tax, or legal advice. There is no guarantee that the views and opinions expressed in this brochure will come to pass. Before making any decision or taking any action that may affect your finances or your company’s finances, you should consult a qualified professional adviser. The information presented is subject to change without notice and is deemed reliable but is not guaranteed. For information pertaining to the registration status of Cerity Partners, please contact us or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov). For additional information about Cerity Partners, including fees and services, send for our disclosure statement as set forth on Form CRS and ADV Part 2 using the contact information herein. Please read the disclosure statement carefully before you invest or send money.


Meet the Author

Dave Campbell

Partner

Dave is a Partner based in the San Francisco office. He provides investment, portfolio design, and financial planning advice for private and institutional clients. Dave’s extensive years of research and consulting have led him to devise creative solutions to complex financial situations, helping affluent clients manage and grow their wealth in a tax-efficient manner.

Prior to joining Cerity Partners, Dave served as a Principal at B|O|S where he led the Financial Planning Committee and helped to research the latest changes in a variety of financial (tax, insurance, retirement plans, education funding, etc.) and estate planning areas that affected the firm’s clients. He also provided education to staff and outside professionals, built analysis tools to address specific client questions, and acted as an expert consultant for clients and the media.

Dave served as a technical editor for Eric Tyson’s Personal Finance For Dummies (7th Edition) and Eric Schurenberg’s 401(k): Take Charge of Your Future. He also co-authored “Roth 401(k) and Roth 403(b) Accounts: Pay Me Now or Pay Me Later” — an article published in the November 2006 issue of the Journal of Financial Service Professionals — that detailed the costs, benefits, and appropriate use of these accounts. Dave has been widely quoted on investment and financial planning topics in leading business publications including SmartMoney, Worth, The Wall Street Journal, and Barron’s. He has appeared in personal finance and investment segments on the NewsNet Central (now CNX Media) and KRON television networks in the San Francisco Bay Area.

Dave earned his Bachelor of Arts in International Relations and Economics from Stanford University and Master of Business Administration in Finance and Investments from the Haas School of Business at the University of California, Berkeley. Dave holds the Chartered Financial Analyst designation and is a member of both the CFA Institute and the CFA Society of San Francisco.

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