I’ve been working in fintech for under a year and I’ve learned a lot during that time. One of the things I’ve learned is that the industry is full of jargon and technical terms that can be hard to understand; case in point: margin loans. I had someone explain it to me and even then it didn’t make sense until finally I was told that “buying stocks on margin is like buying a house with a mortgage”.
Imagine you’re in the market to buy a house. You’ve got a good job, you’ve done your research, and you have a great credit score. You’re ready to buy the house of your dreams… but you don’t have enough money saved up to cover the total cost.
Enter buying stocks on margin.
Assuming you want to buy stocks, but you don’t have the funds, you can put up a certain amount of money and your broker puts up the rest. In the same way that a mortgage can be used to purchase a house, a margin loan can be used to purchase stocks. The risk with buying stocks on margin is that the stock value could go up or down.
So, let’s say you buy a stock with a margin loan, let’s look at the two situations you could be in.
Situation 1, the happy path: the price of your stocks go up. You’d get to keep the profits from the increased value of the stock, just like if the value of your house went up. If you buy a stock for $200 with $100 being a margin loan and the price goes up to $250. You would keep the $50 profit. In this situation your ROI would be 50%, since you only had to put up $100 to make $50. If you had paid the full amount outright, your ROI would be 25%.
Situation 2, the unhappy path: the price of your stock goes down and you could potentially owe more money than you originally borrowed. This is because you’re on the hook for any losses incurred in the stock market. It's like having negative equity on your house, i.e. that value of your house ($400k) is less than your original Morgage ($500k). If you defaulted on mortgage payments and had to sell the house, you would still owe the bank another $100k.
Keeping the same amounts as the previous situation, you’ve bought a stock for $200 with $100 being a margin loan, but this time, the value of the stock has dropped down to $50. You’d have lost your initial investment and have to pay the $50 loss back to the broker.
One main strategy that you can adopt to limit your loss is setting up a “stop loss order” (yes, there’s another jargon).
For example, you can set up a stop loss order to automatically sell your stock if the price drops below a certain point. If you bought your stock at $200 with $100 being a margin loan, assuming the price went up at some point, and it is now about to fall below $100 you may want to set up an automatic stock sale at a little than this point – so for example, $110, this way you won’t end up owing more money than your initial investment.
When you buy a stock on margin you will have to pay interest on the initial loan amount. In today’s high interest rate environment, this becomes more of a factor to consider. This is similar to an interest only mortgage. Like a mortgage you are able to pay it off and stop paying interest if whenever you have the funds to do so.
Buying stocks on margin can be a great way to invest and increase your exposure in the stock market, but it’s important to understand the risks before you get started. Investing in the stock market is already a risk, doing so on margin is an additional risk that you need to be prepared to take.
** Please note that this article is written for educational purposes only and illio in no way endorses or not the use of margin loans.