Please ensure Javascript is enabled for purposes of website accessibility

Will Margin Loans Make You Rich?

By Dan Caplinger – Updated Apr 7, 2017 at 12:40PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Levering up is possible, but is it smart?

For a long time, many businesses owed a big part of their success to a simple financial concept: leverage. By borrowing money cheaply and earning superior returns on their capital, businesses multiplied their profits.

But as the financial crisis in 2008 showed, leverage-driven businesses brought the markets to the brink of collapse. With that recent history as context, is taking on leverage in your personal finances a good idea, or does it leave you open to too much risk?

Mimicking dividend leaders
It's common sense that when interest rates are low, it makes sense to borrow money. For instance, with mortgage rates at record lows and home prices relatively low, it's been a long time since homes were more affordable than they are now, at least in terms of how much you'll pay in monthly payments. Moreover, leverage-driven businesses like mortgage REITs Annaly Capital (NYSE: NLY) and American Capital Agency (Nasdaq: AGNC) have thrived from the low-interest-rate environment, taking advantage of an upward-sloping yield curve to borrow cheaply and earn greater income on mortgage-backed income securities.

Yet borrowing to lever up your personal investment portfolio can potentially involve a lot more risk to your finances. Conceptually, buying stocks on margin isn't much different from using leverage to buy a home, but in practical terms, the practice raises much more dire concerns, with reminders of past financial calamities resulting from overuse of margin.

It can be done...
Thanks to advances in the online brokerage industry, it is possible to make prudent use of margin. Many brokers still charge ridiculously high margin rates of 8% or more on relatively small loan balances. But if you shop around, you can find some discount brokers that currently charge less than 2% on outstanding margin loans.

With such low margin rates, it's easy to find investments that will provide enough cash flow to cover interest payments. There's no shortage of blue chip dividend stocks that yield more than 2%, and you can even find many corporate bonds that will pay you enough to cover margin interest.

...but at a price
The problem, though, comes from the impact that borrowing on margin can bring. As a research paper (link opens PDF file) cited in a recent Wall Street Journal article discusses, leverage introduces its own unique risks, most notably the risk that temporary adverse market conditions will trigger margin requirements that necessitate immediate liquidation of assets to repay the loan.

Countless stories show the magnitude of margin-call risk. Chesapeake Energy (NYSE: CHK) CEO Aubrey McClendon suffered one of the most famous margin calls in industry, losing almost his entire $2 billion stake in the company after plunging energy prices pushed Chesapeake stock down sharply. General Growth Properties (NYSE: GGP) president Bob Michaels had a similar experience, selling more than 1 million shares in the span of only a couple of months during the financial crisis. More recently, former Green Mountain Coffee Roasters (Nasdaq: GMCR) board chair Robert Stiller and lead director William Davis were booted from their board leadership positions after having to liquidate positions in violation of internal trading policies due to margin loans.

Making the choice
Despite the dangers involved, prudent use of margin isn't automatically a bad thing. As a way of providing short-term financing, it can be much more efficient and less expensive than tapping other sources of funds.

For longer-term purposes, though, you need to make sure you're paying 2% and not 8% if you're going to go the margin route. Overcoming an 8% hurdle under current market conditions is difficult, and if shopping around can save you 6 percentage points, it's worth the effort on loans of any significant size.

Perhaps the most important thing about margin is never to overuse it. History is littered with countless tales like the ones described above in which investors were far too confident about their stocks' prospects. Using margin can potentially take away one of your biggest advantages as an investor: the ability to be patient even through hard times.

Margin loans can get you better results in a low-interest-rate environment. But don't look at margin as a way to get rich quick. If you make that mistake, you'll greatly increase your chances of a huge loss.

Green Mountain may have value as a past cautionary tale, but where do investors in the coffee stock stand now? Find out the latest in the Fool's premium report on Green Mountain, in which our top analysts look to the future to see how the company is dealing with big competitive threats. Click here and get your copy today.

Fool contributor Dan Caplinger would be content to get rich slowly. You can follow him on Twitter @DanCaplinger. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital and Green Mountain, as well as creating a bear put spread position in Green Mountain. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy wants you to reach your goals.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Annaly Capital Management, Inc. Stock Quote
Annaly Capital Management, Inc.
$20.60 (-8.85%) $-2.00
Keurig Green Mountain, Inc. Stock Quote
Keurig Green Mountain, Inc.
AGNC Investment Corp. Stock Quote
AGNC Investment Corp.
$9.62 (-7.68%) $0.80
Chesapeake Energy Corporation Stock Quote
Chesapeake Energy Corporation
Brookfield Property REIT Inc. Stock Quote
Brookfield Property REIT Inc.

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 09/26/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.