Investing With Borrowed Dollars

You may not realize it, but you can invest in stocks not only with your own money, but also with money borrowed from your broker. That’s called investing “on margin.”

When you buy on margin, you’re borrowing money from your brokerage at a variable interest rate while using the stocks in your portfolio as collateral. Imagine, for example, that you hold $10,000 of stocks and you borrow another $10,000 to invest in more stock. You’ll have $20,000 worth of stock in your portfolio. If it doubles in value to $40,000, you’ll have made $20,000 (less interest charges) with only a $10,000 initial investment.

What if your holdings fall in value by 50 percent, though? Then your $20,000 of holdings will be worth $10,000, and you’ll still owe $10,000 (plus interest). Your holdings dropped by 50 percent, but margin boosted that to a total, 100 percent, loss. Margin amplifies both gains and losses.

It can be tempting to invest on margin, but it’s risky. If you’re paying, say, 8 or 9 percent margin interest, you’d better be confident your stocks will appreciate by more than that, and there’s never any guarantee of that. (Margin rates these days are roughly in the 5 to 10 percent range, with big borrowers getting the lowest rates.) Indeed, the stock market has averaged annual gains of no more than about 10 percent over many decades.

Here’s how things can get ugly: When your margined securities fall below a certain level, you’ll receive a “margin call” from your broker, requiring an infusion of additional cash. If you can’t raise the cash, the brokerage will sell some of your holdings to generate the needed funds. This can sting, sometimes resulting in short-term capital gains taxed at high rates. Margin can reduce your investing flexibility, too. If you’ve borrowed money to invest in a stock and it falls sharply, you may end up forced to sell when you’d rather wait it out.

You can do quite well in stocks without using margin, and that’s the safest route.