Every investor wonders about margin at some point
Using leverage in real estate is a no brainer. A 20% down payment gives you control over a property that’s worth 5 times your initial investment.
Mortgage interest rates are at historic lows which make borrowing money very cheap.
Similarly to real estate, you can use leverage in stocks to give your portfolio a boost.
Buying stocks on margin is a type of leverage that grants you more buying power. Only have 100 shares of Apple? You can use margin to add an extra 50 shares to your portfolio. Now you end up with 150 shares of Apple for boosted gains.
But does it make sense to buy stocks using margin?
Let’s start by looking at the margin interest rates. Your interest rate is based on how much money you borrow. The more money you borrow, the lower the margin rate.
That presents an issue for investors just getting started out, and you’ll see why in these Fidelity rates below.
Even though Fidelity’s margin interest rates are lower than most brokers, they are considerably high compared to mortgage interest rates.
If you want to borrow $20,000, you’d have to pay an 8.325% annual interest rate on that $20,000. That’s an extra $1,600/yr in addition to the $20,000 which you will have to repay to your broker.
Considering the average return of the stock market is 10%, you have little room for error.
If you make a 10% annual return on the extra $20,000, you will still have to pay the 8.325% interest rate and the initial principle. That leaves you with a 1.675% gain on $20,000. An extra $335 if you decided to pay off the entire margin loan in that moment.
However, that average 10% annual growth isn’t for most people who invest with margin. You won’t find any dividend investors applying this investing strategy (the margin interest rate is greater than most dividend yields. Therefore, it makes no sense for dividend investors to get involved with margin).
Most people who use margin to increase their buying power seek abnormal returns. No one goes into margin looking for an extra 1–2% growth for their portfolio.
People use margin to invest because they want a 20% annual return or higher. If you get that type of return, the margin is more justified. The borrowed $20,000 turns into $24,000. If you used that $24,000 to pay off your margin loan in a year, you’d end up with $2,335 because we have to factor in interest ($20K * 8.325% = $1,665 interest payment).
The Big Danger With Margin
Earlier, I mentioned that many people who invest in margin do it for abnormal returns.
The problem with abnormal returns is that they can go in both directions. A 20% gain is great, but a 20% loss is more than a 20% loss.
Not only does the borrowed $20,000 become $16,000, but you still owe $20,000, and you still owe the interest payment. No broker will feel bad for you if you invest using margin and end up with a massive loss.
So you didn’t lose $4,000 when your $20,000 became $16,000. You actually lost $9,665 because you have to come up with the extra $4,000 AND still pay the $1,665 interest.
You can ride it out and wait for the stock to recover…but what if it doesn’t?
You can keep holding and hoping for a comeback, but eventually your broker may issue a margin call. A margin call requires that you add more cash to your account to cover your losses. Your broker wants to make sure they’ll still get paid.
If you don’t add more money to your account during the margin call, your broker can force you to sell out of enough positions so they recoup the margin money they gave you.
This is the worst case scenario for people who invest with margin, and it’s a main reason why most people don’t use margin to invest.
Margin can dramatically increase your return if utilized correctly. While the risks can get extremely high, you can manage the amount of risk you take on. Having a $500,000 portfolio and requesting a $250,000 margin loan is as risky as you can get.
However, you can ask for a smaller margin loan that represents only 10% of your portfolio. A $50,000 margin loan still presents the same risks of margin, but you do lower your risk with this approach.
While the margin interest rate is higher for a lower loan amount, the interest rate difference between a $50,000 loan and a $250,000 loan is only 0.3% (taking the difference of 6.875% and and 6.575% from Fidelity’s margin interest rates).
This difference isn’t as much of a big deal compared to the $20,000 margin loan which is at 8.325%.
Another key factor with margin loans is that you can pay them at your convenience. You will still have to pay the interest, but you can chip away at the principal at your convenience.
The more you do chip at the principal, the lower the interest payment will become, so it is good to chip a little of it away each month like a mortgage.
Your broker doesn’t want you to repay any of that margin because then they get to keep on charging interest. While chipping down the margin loan will reduce your buying power in the short-term, it will lower the interest payments over the long-term which will help immensely.
In theory, you could hold onto a stock for years and just pay the interest rate. This is where the power of buying stocks with margin comes into play, especially if you select an index fund.
Let’s return to our conversation about the 10% annual return the stock market provides. While not every year guarantees a 10% return, it is an average that has played out in history.
In one year, your $20,000 turns into $22,000.
In year two, your $22,000 turns into $24,200.
By the time Year 5 approaches, your $20,000 would have turned into $32,210.20.
While your returns compound, your margin interest rate doesn’t. Using Fidelity’s rates, your interest payment on $20,000 is $1,665 in Year 1.
If you choose to not pay off any of your principal, your Year 2 interest rate payment will also be $1,665. As long as you do not repay your principal but stay up to date with your interest payments, you’ll stay at $1,665 each year.
Interest rates can rise, but they don’t compound the way stocks do. And you can mitigate your risk in that area but chipping away at the principal each month.
Assuming interest rates stay the same and you didn’t pay any of your principal, you’d pay $8,325 in interest over the course of 5 years.
In those same 5 years, you’d have $32,210.20 with the annual 10% return. If you decided to use that money to pay off the entire principal, you’d end up with an extra $3,885.20 with the help of other people’s money (math below).
The return on your $8,325 interest expense is a $12,210.20 which is good for a 46.7% gain over 5 years with money you previously didn’t own.
If you’re new to investing, get a lot more familiar with it before you consider buying stocks with margin.
If you are a day trader, stay away from margin. Gambling with leverage is an easy way to lose it all, especially for a beginner.
Investing with margin amplifies the performance of your portfolio…for better or for worse. It’s not for everyone, but it is certainly for some investors. I wouldn’t even consider investing with margin unless I could get a margin interest rate under 7% and have the margin loan be less than 10% of my portfolio’s size.
With a small entry point (percentage wise) and some years of investing under your belt, investing with margin may be worth a shot.