Margin accounts: an advantageous option

By August 10, 2017Blog

Margin accounts can help you have a better stock market exposure and access to competitive borrowing rates. While it is not a panacea, a margin account is an option worth exploring.

With a margin account, you can borrow funds from your broker under certain conditions. It’s a good way for the investor to have a source of ready cash to take advantage of market opportunities, or to use as an emergency fund, or purchase goods outside of the margin account or to contribute to your RRSP.

Variable margin

The way it works is simple: by transferring quality assets from an unregistered account to a margin account, you can borrow an amount based on the market value of the eligible securities held in the account.

The margin or maximum advance granted by the broker will vary depending on the investment product. For example, it may be 95% to 96% of the value of government bonds, 94% of term and index-linked GICs, 99% of Treasury bills, or 50% of mutual funds. For shares, the advance is tied to the value of the security (up to 70% for shares trading at $5 or more; up to 50% for shares trading between $2 and $5).

The investor will have to provide a minimum amount and pay a margin deposit, which is a security deposit of sorts. Thus, margin accounts do not have a pre-determined fixed amount of margin as is the case for a bank line of credit. They are variable and calculated daily based on the value and type of product held in the account.

To illustrate how a margin account works, let’s look at an investor who would like to invest in company XYZ at $10 per share (security marginable up to 70% of its value) with a deposit of $10,000. Since the investor has a margin account, she can purchase 3,333 shares for a total amount of $33,330, of which $23,330 is advanced by the broker and $10,000 comes from the deposit, which is the set minimum she has to cover. With a cash account, the investor would be able to purchase only 1,000 shares because she had just $10,000 of her own money.

Margin accounts: number of benefits

Competitive interest rates are just one of the considerable benefits of margin accounts. They stand out in fact versus those that you would get on personal loans, credit cards or lines of credit. With a margin account, interest rates vary depending on the amount borrowed, but for a sum of $0 to $9,999, you could qualify for the NBC prime rate plus 1.25%; from $10,000 to $99,999, NBC prime rate plus 1%; and for $100,000 and over, NBC prime rate. Currently the prime rate is 2.70% ¹, meaning there are big savings offered!

Another benefit that bears mentioning is the leverage effect, which gives investors greater market exposure and can maximize their returns. For example, let’s say an investor purchases 1,000 shares for $10 each (security marginable up to 70%), covering the minimum with $3000 of his own money and using a $7,000 advance from his broker. If the security’s value increases to $12, the return will be 67% because he spent just $3,000 initially. In comparison, the return would be only 20% if he had made the purchase with a cash account and used $10,000 of his own funds.

What’s more, the broker can make another advance based on the portfolio’s new value. That’s two big advantages in one!

In addition, when the margin is used to generate income from the stock market, the interest could be income-tax deductible.

It should also be said that you don’t have to use the margin, because the account can be managed like a cash account, making it very flexible.

Risks to consider before opening a margin account

Conversely, the leverage effect that boosts returns can also put the squeeze on, potentially leading to a margin call. If the value of a share falls and the market value decreases, the broker’s maximum advance will decrease as well, resulting in a negative difference. This variation will increase even more if, following the drop, a security that was marginable up to 70% then becomes marginable up to 50%.

In the event of a margin call, the investor will have to provide new capital so as not to exceed their borrowing capacity for the security. To do this, cash or securities can be deposited into the account or securities already held in the portfolio can be sold.

To prevent clients from finding themselves in margin call situations at the slightest market fluctuation, brokers require a cushion corresponding to a certain percentage of the loan value of the largest account position.

While flexible, margin accounts have a few risks that you should be aware of before taking the plunge.

Conditions to enable a margin account

To be eligible, investors must meet certain criteria. For example, for National Bank Direct Brokerage (NBDB), you must have an annual income of at least $35,000, a net worth of $10,000, and a credit report that satisfies NBDB’s criteria, in addition to holding assets worth at least $5,000 in your margin account.

Margin accounts are not for every investor. It’s best to have a good risk tolerance and sufficient market knowledge in addition to being relatively comfortable financially.

¹ This rate is subject to change from time to time without notice.

Note that the use of borrowed money to finance the purchases of securities involves greater risk than purchases using your own funds. When borrowing money to purchase securities, you are required to repay the loan, including its cumulating interests, in accordance with its terms, even if the value of the securities purchased declines.

Edited on 6 April 2017 by