Cash Account vs. Margin Account: What’s the Difference?

For investing, the type of brokerage account you choose can significantly impact your trading strategy, potential returns, and level of risk. Two of the most common account types you'll encounter are cash accounts and margin accounts. While both serve as gateways to the financial markets, they operate on fundamentally different principles and have distinct advantages and drawbacks.

While cash accounts offer simplicity and built-in discipline, margin accounts can be powerful tools for experienced investors who fully grasp their mechanics and risks. Cash accounts, the more straightforward of the two, limit you to investing only the money you have. This time-honored approach aligns with the adage "don't spend what you don't have" and provides a clear boundary for your trading. Meanwhile, margin accounts introduce the concept of leverage to individual investing, allowing you to borrow funds from their broker to purchase securities. This can amplify potential gains but also magnifies risk and introduces complexities that demand a more sophisticated understanding of the market.

Below, we examine the key differences between cash and margin accounts, examining their features, benefits, and potential pitfalls. By analyzing these accounts in detail, you'll be better equipped to decide which type best aligns with your finances, investment goals, and risk tolerance. 

Cash Account

Cash accounts are the most basic and common type of brokerage account, serving as the base from which most individual investors trade. In a cash account, you can only buy securities using the funds you have deposited. This straightforward approach means paying cash up front since all transactions are fully funded by the investor's own money.

When you open a cash account, you deposit funds via bank transfer, check, or wire transfer. These funds then become available for investing in stocks, bonds, mutual funds, exchange-traded funds (ETFs), etc. The key characteristic of a cash account is that the investor can only buy securities up to the amount of cash available in the account. For example, if you have $5,000 in your cash account, you can only buy up to $5,000 worth of securities.

One important aspect of cash accounts is the settlement period. When you sell a security, the proceeds from the sale are not immediately available for new purchases. The standard settlement period for most securities is T+1, meaning the transaction settles a business day after the trade date. During this period, the funds are considered unsettled and can't be used for purchases.

Advantages of Cash Accounts

There are benefits to using a cash account for trading:

• Simplicity: Your trades are limited by the cash in your brokerage account, and you can't make complicated trades like opening short positions. You also don't have to worry about accidentally taking on too much debt and facing a margin call.
• Allows for buy-and-hold: With a cash account, you can hold investments whether they rise or fall in value. If you have a margin account and use margin to buy securities, your brokerage may force you to sell if their value falls too far.
• Earn interest: If you have money that you don't invest, you can keep it in a money market account and earn interest on that balance.

Disadvantages of Cash Accounts

Though cash accounts have advantages, they also have some downsides:

• Fewer kinds of trades available: Cash accounts limit you to only making certain types of trades. For example, you may not be able to trade some or any types of options or open short positions.
• Your balance limits your potential returns: You can only invest the cash you have. A margin account lets you borrow money to invest, increasing your potential returns, but also your potential losses, through leverage.

Margin Account

A margin account allows you to borrow against the value of the assets in the account to buy new positions or sell short. You can then leverage your positions and profit from both bullish and bearish moves in the market. Margin can also be used to make cash withdrawals against the value of the account as a short-term loan.

When a margin balance (debit) is created, the outstanding balance is subject to a daily interest rate charged by the firm. These rates, which can be quite high, are based on the prime rate plus an additional amount for the firm. Below are the rate schedules for three major U.S. brokerages.

Let's walk through an example to clarify how margin accounts work. Suppose you have a margin account and want to take a short position in XYZ stock since you believe it's likely to decline soon. If the price does indeed fall, you can cover your short position by taking a long position in XYZ stock. That way, you can profit from the difference between the amount received at the initial short-sale transaction and the amount you paid to buy the shares at the lower price, minus your margin interest charges.

In a cash account, you must use other strategies to hedge or produce income on their account since you must use cash deposits for long positions only. For example, you can enter a stop order to sell XYZ stock if it drops below a specific price, which limits your downside risk.

Owners of margin accounts must maintain a specific margin ratio. You'll receive a margin call if the account value falls below this limit. This is a demand for you to deposit more cash or sell some securities in your account to bring the account value back within the limits.

Advantages of Margin Accounts

Margin accounts offer some benefits for experienced investors.

• Higher potential returns: Borrowing money to invest lets you invest more. Investing well will boost your returns; not doing so equally amplifies your losses.
• Access to more complex securities: Margin accounts let you trade futures, options, and other more complicated securities, gaining you entry to more advanced investment strategies.
• Secure your loan with your portfolio: Margin accounts are one of the easiest ways to borrow against your portfolio, and most brokerages base the amount you can borrow on the size of your portfolio. As your portfolio grows, your borrowing limit also increases.

Disdvantages of Margin Accounts

Margin accounts aren't right for everyone—in fact, they're probably not a good idea for many retail investors. It's important to consider their drawbacks.

• Higher potential losses: Borrowing money to invest increases your potential gains but can also augment your losses. In the worst-case scenario, you could lose more than you have in the account, leading to you owing a debt to your brokerage.
• Minimum balance requirements: Some brokerages require minimum balances in the thousands of dollars before you can open a margin account.
• Margin calls can force you to sell: If you use margin to buy a security and its value drops, your account may fall below your broker's required equity level. If this happens, you may be forced to sell at a loss—then perhaps watch from the sidelines as that security rises in price later on.

Other Uses of Margin Accounts

In a margin account, you can lend out securities to another party. In addition, the brokerage firm can use securities as collateral at any time without notice or compensation to the investor if they hold a debt balance (or a negative balance) on the account. If the account has a credit (is in the black), where you haven’t used the margin funds, the shares can’t be lent out.

The borrowers of stocks held in margin accounts are generally active traders, such as hedge funds. They are typically trying to short a stock or cover a stock loan that has been called in. Investment firms that need an underlying instrument for a derivatives contract might borrow margined stocks from a brokerage firm, which may also pledge the securities as loan collateral.

In addition, if your margined shares pay a dividend but are lent out, you won't receive it because you aren’t the official holder. Instead, you'll receive “payments in lieu of dividends,” which may carry different tax implications. When the shares are lent out, you typically also lose voting rights.

Using a Margin Account vs. a Cash Account

Margin and cash accounts are used for investing, but how you use them can differ.

Suppose you want to buy shares in XYZ Corp. You have $25,000 in your account, and shares are trading at $100 each.

With a cash account, you can buy up to 250 shares by using your entire account balance. You can hold those shares for as long as you want—whether they rise or fall in value—and can sell them when you wish.

With a margin account, you can buy 250 shares using your own funds. You can then borrow as much as another $25,000 to buy an additional 250 shares. Typically, you'll want to sell the shares soon afterward because you'll owe interest on the $25,000 you borrowed.

If the price of XYZ Corp's shares rises to $150, you can sell your investment. With a cash account, you'd profit $12,500 and have $37,500. If you'd used a margin account and bought an extra 250 shares, you'd profit $25,000, minus interest, and have $50,000 minus any interest paid.

However, suppose that before XYZ rose to $150, it fell to $50. With a cash account, your losses would total $12,500 if you sold at that point. With a margin account, you'd have lost $25,000, the entire account balance. Your broker would likely make a margin call, forcing you to sell the position at a loss, so you wouldn't be able to wait for future price increases.

In general, cash accounts are best for long-term investments and buy-and-hold investors, while margin accounts are for those who make more frequent trades.

The Bottom Line

Investors can buy securities through a cash account or a margin account. The difference is in the requirements each has.

In a cash account, all transactions must be made with available funds. When buying securities, the investor must deposit cash to settle the trade or sell an existing position on the same trading day so that cash proceeds are available to pay for the buy order. A margin account allows an investor to borrow against the value of the assets in the account to buy new positions or sell short.