When you buy shares of stock for your portfolio, you probably pay the broker in full. But you can also purchase investments on margin, or by borrowing the stock from the brokerage firm. The interest rates charged by brokerage firms are typically lower than what you can get by borrowing elsewhere.
How much can you get? For most securities, the maximum margin loan allowed is 50 percent of the value of your portfolio. That means if you have $100,000 worth of stocks, bonds and mutual funds, you can borrow $50,000 on margin. (However, this is a federal rule and individual brokerage firms may have their own policies.)
By using margin, you can increase your potential profits. If you have a $100,000 stock portfolio, a maximum margin loan could boost your holdings to $150,000. So if your stock goes up in value by 20 percent, you’d have a $30,000 gain, instead of just a $20,000 gain. Even if you’re paying 10 percent interest ($5,000 on a $50,000 loan), you’re still $5,000 ahead.
After taxes, the results might even be better. You can write off interest on margin loans against taxable investment income, including capital gains. So, once you deduct the interest you’re paying on your margin loan, your real cost of money might be, say, 6 percent instead of 10 percent.
Meanwhile, your portfolio continues to appreciate, tax free, until you sell the holdings at a gain. Even when you sell, your profit might be taxed at the favorable rate for long-term capital gains. In that case, you’re borrowing at less than 6 percent, after tax, to earn 10 percent or 15 percent, tax-deferred.
Warning: Despite the advantages, there are plenty of risks. Many brokers have a rule: A 28 percent drop in value on a 50 percent margin account generates a margin call — a demand for more cash or collateral. In the event of a margin call, you usually don’t have much time to come up with the money. And if you don’t comply, the broker can sell your securities and use the proceeds for loan repayment. To be on safer ground, yet still have a chance to boost your returns, use less margin. At 20 percent margin, for example, you’re not apt to get a margin call until your portfolio drops in value by 70 percent.
Using low margin levels might enable you to keep a long-term loan outstanding at a reasonable rate — after tax — while your stocks earn long-term returns.
In any event, don’t be caught unaware. If you see the value of your portfolio declining, deposit more money into your brokerage account so that you reduce your loan and the chance of a margin call.
And always keep in mind what you can lose. Using margin is a way to magnify your profits if you’re successful but be prepared for the possibility that your portfolio value could suddenly drop.
One More Caution
You can’t deduct margin interest on your tax return if you buy or hold municipal bonds or municipal bond funds. So if you want to use margin, it’s best to stick with stocks and other privately-issued investme
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