A margin account allows you to borrow at a very competitive rate on the investments you hold in your account or on part of the purchase price of the securities you wish to acquire. The maximum amount borrowed (called the broker’s maximum advance) varies depending on the type of investment you are considering, as well as its market value.
You must deposit a certain amount (called the margin deposit) as partial settlement of the transaction. The sum of the margin deposit and the broker’s advance equals the total cost of the trade.
Daily interest on the loan is calculated on the margin account’s debit balance every month.
Example of buying on margin in a margin account
Robert wants to purchase 1,000 shares at $10 each, anticipating that the market value of these shares will increase. This transaction requires him to invest a total of $10,000 (1,000 x 10).
This security is eligible for a reduced margin, up to 70% of its total value. NBDB can therefore lend Robert $7,000 to make the purchase, leaving him with only $3,000 to invest with his own funds.
Presuming that the stock climbs to $14 and that Robert sells his shares, he will have realized a gain of $4,000.
Considering that he only invested $3,000 for this investment, this transaction will have provided him with a 133% yield, excluding interest payments. If, on the other hand, Robert had funded this transaction by himself and paid the full $10,000, that same growth would have only yielded a 40% return.
But beware: This leverage effect also applies should markets tilt the other way. Losses can also carry a much heavier burden if they are realized in a margin account instead of a cash account. If the value of the purchased shares drop below a certain level, your account will be subject to a margin call. You will then have to immediately liquidate certain assets or deposit cash in our account. If the margin call is not immediately met, you must then sell the shares, at our discretion, to cover the owing balance.
Using borrowed money to finance the purchase of securities involves greater risk than purchases using cash resources only. If you borrow money to purchase securities, your responsibility to repay the loan and pay interest as required by its terms remains the same even if the value of the securities purchased declines.