Even if you're not an investor, you've likely heard of the dreaded margin call. It's a ruinous term that means stocks or funds you've offered as collateral for a loan from your broker have fallen below a pre-defined minimum value requirement. When that occurs, you have one of two choices: add more money to your account, or allow your broker to sell securities to raise cash.
How is that a good deal?
Great question. In many cases, margin isn't a good deal at all. Just ask Benjamin Graham. Like many others at the time, the father of value investing borrowed heavily to pad his portfolio during the great stock market bubble of the 1920s. And, like the rest, Graham was nearly ruined by the margin calls that came when the market crashed in October of 1929.
But, of course, not all portfolios are going to be subject to a margin call. Only the most leveraged are susceptible. And by "most leveraged," I mean those investors who use the maximum margin. Often, that's 50% of the underlying value of the securities held in the account. So, for example, if you have an index fund that's worth $10,000 in a taxable margin account -- tax-advantaged retirement accounts aren't marginable -- you may be able to borrow $5,000 from your broker.
When margin comes calling
A margin call would occur when the value of the collateral -- in this case, the fund -- falls below the 50% equity requirement.
Let's say, for example, that your $10,000 fund falls to $9,000 in value. Since your broker requires that your loan -- that is, your margin -- not exceed 50% of the value of the underlying collateral, you'll be responsible for a $500 margin call.
Here's how the math works: $5,000 (loan balance) divided by $9,000 (collateral value) equals 56%, indicating the account is out of balance and subject to a margin call. The size of the call is determined by the difference between the outstanding margin balance ($5,000) minus the equity requirement ($9,000 x 0.5, or $4,500). That's $500.
Brokers such as Fidelity, Charles Schwab, and TD Ameritrade will often give you five days to make good on the margin shortfall. So, if your fund rises back to $10,000 in that time, the margin call is, um, called off. If not, you'll either have to deposit more cash or let your broker sell shares.
Outside the margins
Complicating matters further is that not all stocks are marginable. Penny stocks such as Pegasus Wireless
More stable stocks and funds, on the other hand, are almost always marginable. Index funds, especially. Fidelity, for example, allows my Vanguard Total Stock Market holdings to be up to 70% leveraged. Individual stocks often sport a higher requirement, but blue chips such as Procter & Gamble
When margin makes sense
So, is there ever a time to use margin? Yes, when an emergency dictates it and margin offers a low enough interest rate to be attractive. So, for example, if you have a $10,000 index fund and you've been stuck with a $2,000 bill for flooding in your house, it might make sense to borrow the proceeds from your broker.
Why? First, because you're borrowing only 20% of equity. Second, because an index fund usually doesn't lose value quickly and shouldn't subject you to a margin call. And finally, Fidelity's current margin rate sits at just under 11%, which offers a better deal than most credit cards and unsecured personal loans.
Follow the money
Margin can be an incredibly dangerous way to enhance stock market returns, especially if, like me, your specialty is volatile fast growers. But as a backup fund for emergencies, margin can be not only appealing but also relatively safe. It's at least worth considering the next time the dishwasher breaks.
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Fool contributor Tim Beyers is hoping to get a few more years out of his dishwasher. He owns shares of the Vanguard Total Stock Market index fund. Get a peek at everything he's invested in by checking his Fool profile. Charles Schwab is a Motley Fool Stock Advisor recommendation. The Motley Fool's disclosure policy always answers the call.