You know that stock that's going gangbusters? The one that's just too good to pass up? The one you really can't afford? Yeah. But wait: What if you bought that stock on margin? Then you could afford it, and the clouds would part, and the angels would sing as all that money was deposited straight into your bank account. Huzza!
Well, let's back up a few steps, shall we?
Buying on margin is a bit like gambling and using your car as collateral; it might turn out OK, but often, you're going to lose your ride home. Let's take a closer look.
Hurray for credit!
Imagine it's 1985. You've heard about this company called Apple (Nasdaq: AAPL ) , and you just know it's going somewhere. The stock's cheap at $15 a share, and you really want to buy 100 shares. Unfortunately, you only have $750 available, so you decide to buy the other 50 shares using margin.
Luckily, Apple is the company you think it is, and a couple years later, your 100 shares are worth $8,000, and you've decided to sell. So what are you left with before taxes? Well, first you have to pay back the margin loan of $750, along with interest. But whatever's left after covering the loan and interest is yours to keep. That's not bad considering you started out with $750.
The down and dirty
But let's consider another scenario. This time, it's the present, and you just know Apple is going to continue its upward climb with the anticipated release of the iPhone 5. Plus, shares are down slightly at $330 a share, so you want to buy 10 shares. This time you have $1,650 of your own and you borrow $1,650 on margin.
Now fast forward five years. In this hypothetical future, things don't turn out so well for Apple. As a result, shares plummet to $200. So your initial purchase of $3,300 is now worth $2,000. You still have to pay back your $1,650 margin loan, so you end up with just $350, less any interest you have to pay. Ouch.
You might be wondering, "Does this actually ever happen?" Yes, it does -- even to high-profile investors who arguably should know better. Just ask Aubrey McClendon of Chesapeake Energy (NYSE: CHK ) , who had to sell almost his entire stake in the company to pay back margin loans when the stock plummeted in 2008. Other past victims include Cedar Fair (NYSE: FUN ) CEO Richard Kinzel, who had to sell shares because of a margin call.
Is it worth it?
Yes, investing on margin has the ability to bring in lots of profit. But, so does winning the lottery. Unfortunately, the chances of hitting it big with either are slim. When you invest your own money, you have the ability to grow it as high as the stock goes, whether that's 10% to 3,000%, while you can only lose what you put in. When you invest using margin, you're not only risking your own money; you're risking the margin and taking on the obligation to pay interest. For a $100 investment, that doesn't seem like much, but if you have $10,000 on margin, things start to look a lot scarier.
Investing money you can't afford to lose is definitely a no-no for Fools. And if you had it to lose, you wouldn't need margins anyway. Want to learn more about margin accounts? Click on the link, or head on over to our Foolsaurus for more information!