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Cash vs Margin Account

As someone in the world of investing with a brokerage, you’ve likely heard of margin and cash accounts. These two account types have fundamental differences.

One is not necessarily better than the other, but it’s important to understand the pros and cons of margin and cash accounts, how they differ, and how to use them so you can make sound investment decisions. 

What Is a Margin Account?

Let’s start with unpacking the question – what is a margin account? Simply put, a margin account is a type of brokerage account which allows the account owner to purchase stocks and various securities with money they borrow from their brokerage.

The money borrowed, or loan, is backed by the customers total cash value and portfolio value within the brokerage. Additionally, the money an investor borrows will include a periodic interest rate. This allows the brokerage to make additional money.

How Does a Margin Account Work?

The main purpose of a margin account is to multiply the investors purchasing power. For example, if the investor has an account balance with the brokerage of $100,000, the brokerage may give that investor an additional $100,000 in margin. 

Now the investor can invest up to $200,000. If they earned 5% on $100,000, they’d net $5,000 in profit. Whereas if they earned 5% on $200,000, they’d net $10,000 in profit.

Even when factoring in the periodic interest rate, the overall net benefit would likely be positive for this investor. These accounts allow the investor to purchase more shares or securities, without having all the cash upfront.

Without question, this has tremendous upsides, but it also increases one’s risk exposure. If you lose money, you must repay the brokerage the principal balance and interest rate. 

Minimum Margin

Minimum margin is the initial amount an investor needs to have in a margin account before the brokerage allows the investor to utilize margin. There is not a one size fits all rule here.

Various brokerages will have a different minimum account size before margin is introduced. 

Initial Margin

Initial margin is the percentage of a security that must be put upfront in cash when trading within a margin account. The minimum level set forward by the Federal Reserve Board is 50%. 

Maintenance Margin

This is another common term a trader or investor must be familiar with. Maintenance margin is the minimum amount of equity an investor must have at all times within the margin account after they purchase a security.

The current maintenance minimum level is 25%. 

What Is a Margin Call?

A margin call is triggered when the value within a margin account falls below the brokerages required amount. The Federal Reserve puts in place this minimum requirement.

However, brokerages are able to set their own requirements at any level above the minimum requirement the Federal Reserve mandates. When a margin call is called, the account owner needs to either deposit more money in the account or begin selling some securities.

If that is not done, the brokerage often reserves the risk to sell securities on your behalf so the minimum maintenance margin is met. A margin call is not a good thing as it means the accounts value is decreasing. 

What Are the Risks That Come With Margin Accounts?

There are a variety of risks that come with trading or investing with margin. The two main risks are:

  • The investor can lose more money. Instead of losing 5% on $100,000, if you use a margin account you may lose 5% on $200,000.
  • If a margin call is pressed forward, a brokerage can sell securities in your account. There is nothing that states these securities must be sold at the most ideal price. 

What Is a Cash Account?

A cash account is a brokerage account where the investor must pay for all the securities/stocks purchased with 100% their own money. These accounts do not use margin to multiply one’s purchasing power.

Whatever you deposit is what you get to trade/invest with. 

How Do Cash Accounts Work?

The best way to understand a cash account is to envision it as a checking account for your investments. The account owner deposits money into this account and then uses that money to buy various investment vehicles within the brokerage.

The investor can buy stocks, Forex, options, etc. More money can be put into the account at the investors will, and the investor can sell their securities and withdraw money as they please. 

Cash Account Settlement Rules

All transactions must be able to be fully settled with the cash in the account. For example, if an investor wanted to buy $25,000 of Apple stock on Tuesday, there must be at least $25,000 in cash in the account.

If the settlement rules are not followed, various penalties could be imposed. Trades in a cash account generally require 2 business days for all the funds to settle before the investor can use those funds to make another trade. 

Should I Open a Margin Account or a Cash Account?

Unfortunately, there is not a clear answer here. On one hand, a margin account has tremendous benefits if used properly.

One can multiply their purchasing power to maximize their return. With that said, a margin account comes with a greater deal of risk as the account owner is essentially trading borrowed money.

A cash account is a great account to set up if you’re not comfortable accepting as much risk, or if you are a new investor. Ultimately, choosing between margin and cash accounts will come down to personal preference and risk tolerance.

Learn From The Pros 

Margin and cash accounts are available with most online brokerages today. These accounts allow investors to buy and sell publicly traded securities at their own will.

Investing in various securities is a great wealth building tool that has stood the test of time. With that said, investing is a serious business.

There is a great deal of risk that comes along with investing, and one can lose a lot of money if done incorrectly. Even though online brokerages make it easy for one to buy or sell a publicly traded stock or option, these platforms do not provide their customers with a custom investment plan.

Working with a financial advisor is a great way to ensure you and your family are making sound financial decisions. The right financial advisor will help you invest in a wide range of securities, will keep your portfolio diversified, and will help maximize your return while reducing your risk.