Margin Credit: Are You at Risk?

This article pulls together the different consequences of purchasing securities on margin.

What Is Margin? Margin is a brokerage account feature that institutional brokers offer to their creditworthy customers. Margin loans allow customers to purchase securities (stocks, bonds, etc.) on credit with little or no money down, using their purchased securities as collateral.

What are Securities? There are several answers to the question "what is a security?" The "Howey test" is often used to define securities as investment contracts in which a person invests money in a common enterprise and is led to expect profits solely from the efforts of others.

Securities are marginable typically if they are stocks and other equity securities that trade over $5 and mutual funds held for more than 30 days.

What is Margin's Bright Side? The great thing about a margin loan is that you can enhance your positive returns by paying for your securities with borrowed money, as compared with money from your own assets.

• For example, let's say you purchased a security for $1000 with $800 of your own money and borrowed $200 on margin at a rate of 8%. Say that in the first year the security increased in value by 15%. In that year, you would have netted a return of $134 ($150 of stock increase less $16 owed on the $200 borrowed). That's an increase of 16.75% on your original $800 instead of 15% - after you've factored the money you had to pay back in margin interest!

• Of course, borrowed money will exacerbate any stock price drops as well. If the stock had suffered a 15% market drop during that year instead, the loss on your original $800 would have been 17% after paying the interest on the $200.

What is Margin's Dark Side? Aside from the chance that in a down market a margin loan will deepen your losses, here are some of the other factors to consider when taking out margin loans:

1. Potential Loss of Economic Rights. Depending on how your margin agreement reads, your broker usually has all of the following rights:

- They can require you to deposit additional money into your brokerage account if a drop in your account value (usually when stock prices are falling) triggers a "margin call."

- If you don't deposit this money, they can sell securities out of your brokerage account to meet your margin call, typically without warning.

- They can sell any fully paid-for securities out of your margin account, not just the ones you purchased on margin.

- They can lend out securities in your stock account, causing you to lose capital gains tax treatment on your stock dividends (it would become ordinary income).

- They can refuse to let you choose which of your securities get sold to meet the margin call.

2. Potential Loss of Voting Rights. You may also lose the right to vote your securities if your stock loan department has lent out the shares. The issuer's records will reflect that the borrowing shareholder has the right to vote the shares, not you. With a margin account, you may also lose the right to vote some of your fully paid for securities, not just the ones you purchased on margin.

Go to www.powerwealthcreation.com/stock-account.html to learn more about how your voting rights are impacted by opening a margin acount.