Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Margin Debt

What it is:

Margin debt is debt obtained from buying on margin.

How it works (Example):

Buying margin refers to borrowing from a brokerage firm (through a margin account) to make an investment.

Let's assume you want to buy 1,000 shares of Company XYZ for $5 per share but don't have the $5,000 necessary to do so -- you only have $2,500. If you buy the shares on margin, you essentially borrow the other half of the money from the brokerage firm and collateralize the loan with the Company XYZ shares. This original loan amount as a percentage of the investment amount is called the initial margin. It is margin debt.

If the value of the Company XYZ shares drops past a certain point, say 25% of the original $5,000 value (or $1.25 per share; this point is called the maintenance margin), the brokerage firm may make a margin call, meaning that within a few days you must deposit more cash or sell some of the shares to offset all or part of the difference between the actual stock price and the maintenance margin. The broker does this because it has lent you $2,500 and wants to mitigate the risk of you defaulting on the loan. Federal Reserve regulations and the broker's internal policies determine the initial margin and maintenance minimum percentages.

Getting a margin call means that not only do you have to pay back the original $2,500 of debt eventually, but you have to pay the margin call. However, if the stock rises from $5 to, say, $15, you've just made $10,000 without investing all of your own money.

Why it Matters:

Margin debt allows investors to make investments with their brokers' money. But they can also add to your losses, and in some cases, a brokerage firm can sell your securities without notification or even sue if you do not fulfill a margin call. For these reasons, margin debt is generally for more sophisticated investors who understand and can handle the risks involved.