Margin Debt: Definition, How It Works, and the Pros and Cons of Using It

What Is Margin Debt?

Margin debt is the debt a brokerage customer takes on by trading on margin.

When purchasing securities through a broker, investors have the option of using a cash account and covering the entire cost of the investment themselves, or using a margin account—meaning they borrow part of the initial capital from their broker. The portion that investors borrow is known as margin debt, while the portion they fund themselves is the margin, or equity.

Using margin debt has both risks and potential benefits.

How Margin Debt Works

As an example of using margin debt to buy securities, suppose an investor who we’ll call Sheila wants to buy 1,000 shares of Johnson & Johnson (JNJ) for $100 per share. She doesn’t want to put down the entire $100,000 at this time, but the Federal Reserve Board’s Regulation T limits her broker to lending her 50% of the initial investment—also called the initial margin. 

She deposits $50,000 in initial margin, while taking on $50,000 in margin debt. The 1,000 shares of Johnson & Johnson that she then purchases act as collateral for this loan.

(Not all brokers would allow Sheila to borrow that much. Brokerages often have their own rules for buying on margin, which can be stricter than those imposed by regulators.)

Advantages and Disadvantages of Margin Debt

Buying on margin has both risks and potential benefits for investors. Generally speaking, it isn’t for beginners or for those who can’t afford to lose money.

Disadvantages

Two scenarios illustrate the potential risks and rewards of taking on margin debt.

In the first, Johnson & Johnson’s price drops to $60. Sheila’s margin debt remains at $50,000, but her equity has fallen to $10,000, which is the value of the stock (1,000 × $60 = $60,000) minus her margin debt of $50,000. The Financial Industry Regulation Authority (FINRA) and the exchanges have a maintenance margin requirement of 25%, meaning that customers’ equity must remain above that ratio in margin accounts.

Falling below the maintenance margin requirement triggers a margin call. Unless Sheila deposits another $5,000 in cash to bring her margin up to 25% of the securities’ $60,000 value, or $15,000, the broker is entitled to sell her stock (without notifying her) until her account complies with the rules. This is known as a margin call.

Here again, brokerages may have stricter rules than the law requires, such as setting their maintenance margin requirement at 30% or 40%, for example.

Advantages

A second scenario demonstrates the potential rewards of trading on margin. Say that in the example above, Johnson & Johnson’s share price rises to $150. Sheila’s 1,000 shares are now worth $150,000, with $50,000 of that being margin debt and $100,000 equity. If Sheila sells commission- and fee-free, she receives $100,000 after repaying her broker. Her return on investment (ROI) is equal to 100%—a $50,000 return on her $50,000 cash investment.

Now let’s assume that Sheila had purchased the stock simply using a cash account, meaning that she funded the entire initial investment of $100,000, so she does not need to repay her broker after selling. Her ROI in this scenario is equal to 50%—a $50,000 profit on her cash investment of $100,000.

In both cases, her profit was $50,000, but in the margin account scenario, she made that money using half as much of her own capital as in the cash account scenario. The capital she has freed up by trading on margin can now go toward other investments if she wishes. These scenarios illustrate the basic tradeoff involved in taking on leverage: The potential gains are greater, but so are the risks. 

The Bottom Line

Buying on margin can allow investors to reap greater gains on a percentage basis if the stock they buy goes up in value. If it goes down, however, they may have to scrape up additional cash quickly before the broker sells off their stock.

While buying on margin can work for savvy (and lucky) investors, it is risky and shouldn’t be entered into by anyone unless they have sufficient cash on hand and can afford to lose it.