How Much Margin Debt in My Accounts Is Considered Appropriate?

Margin trading can amplify gains and returns, but it can also create more losses. Oselote/Shutterstock

When we talk about debt, we are generally expressing our concern that we may have taken on too much of it. Perhaps making the monthly payments is becoming onerous, and indeed we can get to the point where excessive debt can sink us into bankruptcy.

But the judicious use of debt can provide what we refer to as “leverage.” Investing $100 and getting a 10 percent return will yield just $10. But when investing our own $100 along with another $100 borrowed, we would enjoy a return of $20.

Leverage is simply using borrowed money to increase your return on investment. Leverage can generate returns that you thought were out of reach. While your returns are potentially higher with debt (leverage), risk is introduced into your investment strategy because, now, you’re on the hook to pay the interest and the principal back over time. And if your investment sours, you may find yourself struggling to pay back the debt that you owe.

What Is Margin Debt?

Margin debt is the debt an investor agrees to take to leverage trading using “other people’s money.” Leverage increases investors’ “trading power” through the proceeds received from the debt. This allows for larger trade positions beyond the amount you had in your investment account. The aim is to increase overall returns in your portfolio using “leverage.”

More specifically, the portion that belongs to the investor is the “margin” while the portion borrowed is the “margin debt.” The margin can also be called “equity.” Equity is important when it comes to how much you must maintain as a ratio in your margin account.

Customers sign an agreement that typically allows them to borrow as much as 50 percent of the purchase price of their intended investments. Said another way, investors can invest twice as much if they take the maximum margin debt their brokerage agrees to lend. But few investors take the max, because this involves higher risk, and we address that risk later in this article.

Let’s say you have $25,000 in your brokerage account. The maximum amount you can borrow on margin is $25,000, giving you a total of $50,000 available to invest. This is referred to as the “buying power,” according to Charles Schwab. If your investment increases by 20 percent in a period, your return on your money is 40 percent before taking into account the interest rate on the loan. Let’s compare an investment without a margin loan to one with the maximum loan amount available:

Leverage: The Risk Associated With Margin Debt

Margin trading amplifies gains and returns, but it works the same way when it comes to losses. The Financial Industry Regulation Authority (FINRA) specifies a “maintenance margin requirement” of 25 percent, meaning your equity must remain above that ratio in margin accounts. A “margin call” occurs when money must be added to a margin account to meet minimum capital requirements. If the investor fails to backfill the account to meet the 25 percent threshold, the broker will begin selling the investments in the account to repay the debt.

Here is an example: Let’s say you just bought $10,000 worth of Nvidia shares: $5,000 from your cash on hand and $5,000 in loan proceeds. At this point, you have equity in the amount of $5,000, or 50 percent. Later, the market value of Nvidia drops precipitously down to $4,000, thus your equity now is a negative $1,000.

Your broker reaches out to you, and since your minimum requirement is 25 percent equity, you have a shortfall that you must correct to avoid having the broker sell all your shares—at a loss—and then backbill you for the remaining $1,000 plus interest. So, you add $3,000 cash, you now have a total of $7,000 in your account: $3,000 in cash plus $4,000 in Nvidia securities at the current market value. The loan remains at $5,000, but you have created $2,000 of equity in the account, or 28.5 percent, slightly above the 25 percent minimum.

You can see how using margin for highly volatile investments could either make you a lot of money or, conversely, break you in a big way!

Determining the Optimal Amount of Margin Debt to Carry

1. Assess your own risk perspective. That can range from conservative with an unwillingness to jeopardize your principal investment, all the way up to riverboat gambler. Since margin trading amplifies both gains and losses, this is first and foremost the most important assessment you must determine.
2. What is your investment timeframe? If short-term trading, investors generally will tend toward higher margin use. But long-term investments best involve less leverage so you don’t have to constantly check the equity level and rack up a lot of interest over a long period of time.
3. At any point in time, market conditions are either in the greedy speculative bubble range, in the fearful range having experienced an earlier large selloff, or somewhere in between. In the first case, we are generally experiencing high volatility and that can translate into significant margin debt losses when the market corrects.
4. You can’t ignore the interest rates on margin loans, because they are the price you pay to borrow. High rates deter the use of margin, whereas lower rates encourage margin debt, as rates reduce your overall returns.
5. The margin requirements discussed above may vary from one broker to the next. Get up to speed with the rates and develop a way to track where you stand relative to potential margin calls so that you aren’t caught by surprise and need to scramble to meet a margin call.
6. Sufficient liquidity to meet those potential margin calls means that cash or near cash on hand should be available and can quickly be transferred to your account if the need should arise.
7. The overall personal financial goals and objectives should drive just how much leverage you want to take on in the grand scheme of your own financial planning.

Summary

As with most of the more complex aspects and areas of financial planning, it can be helpful to consult with your financial adviser to jointly come to an agreement on what will constitute an appropriate level of margin debt. The adviser should first be made aware of point 7 above, your personal and thorough financial plan that reflects your life goals and objectives.

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