What is Margin Debt?
Margin Debt is defined as the money an investor borrows from a stockbroker for investment purpose in the margin account, where the stocks purchased can be used as collateral for this loan, the portion of the stock purchase which is borrowed from the stockbroker is margin debt and other portion which is self-funded is known as margin or equity.
History of Margin Debt in the USA
- Since the 1929 market crash, Federal authorities had given the responsibility of margin loans to SEC (Securities and Exchange Commission) Regulation T in 1934.
- The initial margin requirement has changed 22 times between 1934 and 1974, ranging from as high as 100% and as low as 40%.
- Since then, there have been several perceptions regarding margin requirement, especially between 1980 and 1990, where Fed decided to accurately measure the risk using Theoretical Intermarket margining systems (TIMS), which was first implemented in 1997 in order to calculate the net capital requirement for brokers.
How Does the Margin Debt Work?
#1 – Initial Margin
- This is the money an investor must put in the margin account initially to buy or sell shares.
- As per the Federal Reserve Board’s regulation 1974, the broker can only fund up to 50% of the initial investment in the margin account.
#2 – Paying off Margin Debt
- Margin debt need not be paid till the time the investor maintains the adequate level of equity in the account.
- Interest is being charged on the borrowed amount, and accrued interestAccrued InterestAccrued Interest is the unsettled interest amount which is either earned by the company or which is payable by the company within the same accounting period. will be paid by the investor as loan balance.
- The interest rate must be lower than the stock growth rate for the investor to earn some profit or at least equal to avoid possible losses.
#3 – Maintenance Margin
- As mentioned earlier, the stocks in the margin account act as collateral against the money borrowed, so the value of the stock must be maintained by the investor.
- As per the margin requirements, if the stock value falls below a certain level, either the investor must sell off some equity to match the margin debt or add some money to maintain that stock balance.
- For example, the maintenance margin is 25% of the equity bought; an investor has bought shares worth $10,000, where he has invested $5000, and the rest is margin debt.
- Unfortunately, the stock value falls to $1000. So, ideally, the value of equity has reduced to 10%. In this situation, the investor gets a margin call to maintain the 25% equity requirement or sell off some portion of the equity.
Example of Margin Debt
- As an investor, if you want to purchase 100 shares of Apple worth $10 each, however, you don’t have $1000 to invest. Rather you just have $500, so you can open a margin account and borrow the rest 50% of the amount from the brokerage firm and collateralize that loan with Apple shares in the account. So, here $500 an investor has initially become the initial margin, and the balance is margin debt.
- So, now there are 2 scenarios where Apple prices can go up or stumble down; if the price soars, it is beneficial for the investor. However, in the other situation, if Apple falls below 25%, i.e., below $2.5, then the broker has to make a margin call to the investor, asking him to maintain the maintenance margin in the account.
- Not only buying shares, but margin debt can also be used to borrow security for short selling.
- An investor can benefit from the upside of any stock without having to invest 100% using margin debt. The investor has to pay the interest, which will certainly reduce the profits against the investor who has invested 100% in cash to buy the stock. However, paying off a portion of the profit as interest is much more beneficial than parking a huge amount of liquidity.
- Margin debt facility encourages investment opportunities for the investors; more and more people will be lured to use this provision to earn handsome profits with the surge in markets.
- As more investors invest in the stock market Stock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price., it will lead to increase liquidity in the economy and boost up different sectors in the country since they will enjoy a high market capitalization.
- In the upside scenario, it is a win-win situation for all the parties involved in the trade; the investor earns in terms of profit, the broker earns interest on the margin debt, and the stock company enjoys high market capitalization.
- Since the broker’s money is used for investment, there is a possibility that if the stock goes down, the alarm bell starts to ring for the broker to maintain the margin requirement.
- This facility will help an investor with low liquidity to invest in the market; however, in case of failure to meet the maintenance margin requirement, the broker has to bear the loss after selling off the equity in the account.
- A large portion of the broker’s fund is parked in the market as Margin debt for its clients; in case of the market crash, there is a huge amount of risk since the broker has the maximum liquidity blocked in the market.
Margin debt is a facility provided by the central authorities to lure investors and encourage investments; it can be used to buy a security or borrow security in case of short selling. Regulation T sets the initial margin requirement at 50%, and the maintenance margin is at 25%, failure to adhere to these requirements will give the broker the right to liquidate the investment. Risk and rewards linked to this debt have to be studied carefully before utilizing this provision.
This has been a guide to What is Margin Debt & its Definition. Here we discuss how does the Margin debt work along with examples, advantages, and disadvantages. You can learn more about from the following articles –