When properly used, debt can be very beneficial. But if misused, it can lead an individual down the path of financial ruin.

A prime example is an often repeated refrain from financial firms espousing the benefits of acquiring debt by using securities portfolios as collateral for margin loans.

On the surface, getting a loan against your securities portfolio might seem very simple and straightforward. You appear to be simply agreeing to use your securities as collateral. On the other side of the equation, a brokerage firm agrees to loan you money based on the value of those securities. What could be easier? 

Not so fast. It's imperative that you read the fine print and understand how these loans operate. You must educate yourself about the almost immeasurable risk that using leverage adds to a portfolio.

Let's examine the ins and outs of margin loans and consider some measured suggestions for anyone considering such a type of transaction in a brokerage account.

First and Foremost

Always read the fine print. Never sign any paperwork without first carefully reading all documentation having to do with a margin loan.

It's a common practice for firms to put all margin loan disclosures in a separate "booklet." This separate entity typically includes disclosures for multiple products. It can take a little digging to identify the sections pertaining to margin loans. But your diligence will be rewarded by becoming fully educated about the terms of the margin loan.

How a Margin Loan Typically Works

Another significant caveat is getting a proper understanding of how much you'll actually be paying a broker for such an arrangement.

The margin loan interest rate charged by most brokers is not a fixed rate. In other words, it might fluctuate over time at a rate determined solely by the broker making such a type of loan.

Margin lending is a very competitive business. As such, interest rates charged by brokers can vary greatly from broker to broker. So, taking some time to properly shop for the best rates available at any given time can be key in terms of protecting your assets and determining how much you'll wind up putting into your own wallet as opposed to a broker's pockets. 

Brokers will frequently negotiate a lower rate for larger margin loans. There is no predetermined payment schedule for margin loans. In fact, as long as your equity remains above a certain minimum equity requirement, you generally aren't going to be expected to make any payments.

The interest you're paying is charged to your margin account and ends up increasing the amount of your loan. As a result, you pay interest on the interest that you're charged. For these reasons, if you're going to utilize a margin loan, it's probably advisable to make at least a minimum monthly payment that covers any interest charges.

Technically, according to New York Stock Exchange (NYSE) and Finra, you need a minimum of $2,000 to open a margin account. Brokerages might have higher requirements, though. 

In addition, it's worth noting that Regulation T of the Federal Reserve Board sets an initial equity-to-loan ratio at 50%. Simply put, an investor must have an initial minimum equity account balance equating to 50% of the value of the securities to be loaned. As an example, assume an investor wants to purchase 5,000 shares of Company Y at a price of $10 per share. The total cost in a cash account would be $50,000.

Instead of paying cash an investor can establish a margin account and deposit an initial margin requirement of $25,000, which would then give the investor a total purchasing power of $50,000.

This is how leverage is created. In this case, the investor purchases $50,000 worth of stock using only $25,000 of his or her own money (or equity) in fully- paid-for securities. In effect, he or she has established a stock position with 2-to-1 leverage.

Maintenance Requirement

Once the position is established, the minimum required level of equity could fall below 50%. This lower equity requirement is known as minimum maintenance or the "maintenance requirement." The New York Stock Exchange has set the minimum amount of equity that must be maintained at 25%. However, most brokers set a minimum equity level above 25%. This is known as the "house maintenance requirement."

In our experience working with investors, this level is typically set in the range of 30% or more. But it's also important to understand such minimums vary by different types of investments -- each brokerage has the right to set different levels on a security-by-security basis, factoring in differing rates of liquidity. Technically, maintenance calls are due immediately.

Of note, you're not entitled to an extension of time on a margin call. Also, mutual funds aren't generally marginable until at least 30 days after a purchase settles. 

Looking at our example above, if we assume a 30% maintenance requirement and the price of our stock position goes from $10 to $7, our total market value would then be $35,000 (5,000 shares x $7 per share). Total debt is still $25,000 so our total equity (market value – debt) is $10,000 ($35,000-$25,000). Since our equity (as a percentage of market value) is now 28.57%, we would experience a $500 "margin call," which will be discussed later.

Several factors are considered when setting the house level:

• How quickly the position can be liquidated
• The price of the individual security
• The collateral is all one security or diversified

The house maintenance requirement is established to protect the broker, not the investor, and to provide some confidence that the broker has enough of a cushion to recoup the loan proceeds should they need to liquidate the position. Before establishing a margin position, make sure you understand how much equity is required for the house maintenance.

Most margin agreements have a provision that allows the brokerage firm to put a lien on all accounts you have with it or any affiliates. This provides the broker with additional collateral to secure your margin loan over-and-above what is in your margin account. The only accounts generally excluded from such a lien provision are IRAs.

Margin Calls

If the equity in a margin account falls below the house maintenance requirement, you'll receive a margin call for the amount needed to bring the equity back to the house requirement. You will have the trade date plus the time it takes to settle to meet this call. Keep in mind that if the securities in the account decline further in value, the amount of the call will increase. 

You can meet the margin call by:

• Selling securities in the account
• Depositing additional cash
• Depositing additional fully paid for securities
• Market appreciation in the value of the securities

If you choose to sell securities in the margin account, then you will need to sell enough to release sufficient equity to meet the call. Depending on the maintenance level you may need to sell three times the amount of the call to raise enough equity to satisfy the call.

In our example, the investor has the option of meeting the $500 "margin call" by:

• Selling $1,667 worth of Company Y Stock ($500/Maintenance Margin of 30%)
• Depositing $500 in cash
• Depositing $715 of fully paid for securities ($500/1-Maintenance Margin of 30%)
• Seeing the price of the stock increase to $7.15 within trade date plus the time it takes to settle

If you don't satisfy the margin call, the brokerage firm reserves the right to sell your securities without notifying you in advance. When the brokerage firm sells securities to meet your margin call, you're not entitled to choose the securities it sells.

Also, most margin agreements include language that allows the brokerage firm to liquidate securities in your account "at their discretion." If they decide to not liquidate and the securities decline to zero, you'll still be liable for the full amount of the margin loan -- plus any interest that has accrued. If the equity in your margin account falls below 25%, you'll receive an exchange call. Typically you must satisfy this call by the end of the next business day to prevent liquidation.

Permission to Lend Securities

When you sign a margin agreement, you're giving the brokerage firm permission to lend out the securities in your account. This is typically done to facilitate the 'short' sale of the security being lent. When someone sells a security short, they're selling something they don't own. In order to settle this type of transaction, the seller must "borrow" the amount of securities sold short.

Frequently, the brokerage firm earns a fee for loaning out your securities and you don't receive any portion of that fee. If any of your securities are considered "hard to borrow," the fee earned by the brokerage firm can be quite substantial. In some instances, your securities being loaned out could limit your ability to exercise your voting rights in those securities.

Other Uses of Margin

In addition to purchasing securities, some brokers may allow you to use margin loans for a variety of personal or business financial purposes -- such as buying real estate, paying off personal credit or providing capital.

Using margin loans for non-securities purposes doesn't change the way such loans work, however. These loans are still secured by the securities in your margin account, and thus subject to the same risks associated with purchasing securities on margin as described above.

The terms and conditions of these loans vary between brokers and are generally specified in the margin agreement. You should carefully consider the margin risks described above, as well as any fees that may be associated with these loans, before using them for any non-securities related purposes. 

Risks of Financial Leverage

Leverage essentially amplifies the gains or losses experienced in your account, which is why it's very popular among hedge fund and private-equity managers. Small gains can become substantial depending on how much leverage you have (i.e., how much debt as a percentage of market value is involved).

Let's use a hypothetical example of Bob and Tom. Both invest in IFA Index Portfolio 100, but Bob utilizes a margin account while Tom has a cash account. Both deposit $100,000 into a regular brokerage account at the beginning of Year X. Bob has $200,000 in purchasing power, given that he can utilize margin up to a 2-to-1 ratio (50%). The $100,000 in additional purchasing power carries an annualized interest rate of 5%.

During this 12-month period, let's suppose IFA Index Portfolio 100 experienced a 2.51% return.

• Tom's total account value is now $102,510 for a total return of 2.51%
• Bob's total account value is now $205,020 for a total return of 2.51%. With $100,000 of debt, Bob's equity grew by $5,020, but remember that Bob has to pay 5% interest on the $100,000 margin loan. This means that he would also pay $5,000 in interest cost during this year. Even though IFA Index Portfolio 100 had a positive return, the interest cost paid by Bob in this generic example essentially wiped away almost all of the gain that he earned. His total personal return ended up being 0.02% ($20/$100,000), with a total account value of $200,020 and total equity of $100,020.

In this hypothetical exercise, since Bob was leveraged at a 2-to-1 ratio, he was able to double his profits (before interest costs) compared to Tom. But this also means that he could potentially double his losses as well. 

What happens in such a scenario when an investment's returns move into negative territory?

So, say in the next calendar year, IFA Index Portfolio 100 generated a return of -40.55%.

• Tom's total market value is now $60,942 for a total return of -40.55%
• Bob's total market value is now $118,912 for a total return of -40.55%. With $100,000 of debt still, Bob's equity shrunk by $81,108 for a total personal return of -81.10% ($81,108/$100,020), before interest costs. After we take into account another $5,000 that Bob would pay, Bob's total equity shrinks by a total of $86,108 for a personal return of -86.09% (-$86,108/$100,020) with total account value of $113,912 and total equity of $13,912.

Bob would also experience a margin call of about $20,300, assuming a 30% maintenance margin requirement. He would have the option of:

• Selling $67,667 in securities and locking in his capital losses
• Deposit $20,300 in cash
• Depositing $29,000 in fully paid for securities
• Or hope that the value of his portfolio appreciates by 18% in total value over the next three days. 

A much more reliable and prudent strategy for taking risk is not to amplify your returns and losses through the use of margin, but to control your risk exposure through your asset allocation between risky stocks and safer bonds. This way, you can avoid "margin calls" during severe market contractions, which force you to liquidate securities at exactly the wrong time, and ride out the upside when markets eventually turn around.

Key Questions to Consider Before Utilizing a Margin Account

• Do you know that margin accounts involve a great deal more risk than cash accounts where you fully pay for the securities you purchase?
• Are you aware you may lose more than the amount of money you initially invested when buying on margin?
• Can you afford to lose more money than the amount you have invested?
• Did you take the time to read and understand the margin agreement?
• Did you ask your broker questions about how a margin account works and whether it's appropriate for you to trade on margin?
• Did your broker explain the terms and conditions of the margin agreement?
• Are you aware of the costs you will be charged on money you borrow from your firm and how these costs affect your overall return?
• Are you aware that your brokerage firm can sell your securities without notice to you when you don't have sufficient equity in your margin account?
• Are you aware that all of your accounts at the brokerage firm, with the exception of IRAs, are subject to a lien to secure your margin loan?

Conclusion: A Form of Speculation

As you can see, margin loans are more complicated than one might think at first glance. Using margin lending to create leverage in your investment portfolio can be viewed as essentially representing a form of speculation. To some, it's viewed as another way of gambling.

When the equity markets have gone up, you feel good because you got lucky and leverage worked in your favor. When equity markets have gone down, however, you subject yourself to the potential of losing much -- if not all -- of your hard-earned savings.

To IFA's investment committee, any potential lucky benefit is hardly worth the risks that come part and parcel with taking out a margin loan. Based on years of experience working with thousands of different investors with different levels of knowledge, our advice on such speculative lending practices comes down to a rather clear conclusion: you're more likely to end up in a better position by investing in a globally diversified portfolio of index funds. Then, invest and relax, thereby letting markets work in your best long-term interests. 

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This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. Take the IFA Risk Capacity Survey (www.ifa.com/survey) to determine which portfolio captures the right mix of stock and bond funds best suited to you. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.