Margin Debt Soars as Borrowers Tap Equities
A growing number of investors are increasing their use of margin--borrowing from the equity in their stock brokerage accounts. And they are using it to buy more than just stocks and bonds.
Investors are using their margin accounts to finance everything from homes and cars to vacations and college costs, experts say. Accordingly, margin debt has soared to record levels.
“There has been an increasing tendency to use margin as an alternative to other forms of credit,” says Charles A. Humm, senior vice president of Merrill Lynch Credit Corp. in Jacksonville, Fla. “For somebody who has a lot of securities and understands how margin works, it’s a great idea. It’s less expensive (than other personal loans) and takes less time.”
Indeed, where the average credit card still costs roughly 17% and interest rates on other personal loans are also frequently in the double digits, margin loans typically cost between 6% and 8.5%.
The rate varies, floating above the brokerage’s “base lending rate,” which is generally somewhat lower than the bank prime rate.
Typically, the bigger the loan, the cheaper the rate. For example, those borrowing more than $100,000 pay just three-quarters of a percentage point over the base lending rate--now 5.5% at Merrill Lynch--for a total of 6.25%. But if you borrow less than $25,000, the loan costs 2.5% over the base rate, or 8%.
Partly as a result of the low rates, margin debt has soared to $49.5 billion--the highest level in history. That’s up a healthy 13% since just the beginning of the year, according to the New York Stock Exchange.
While the bulk of margin loans are still used to purchase additional stocks and bonds--the traditional use of margin credit--a growing percentage is being borrowed to finance small business expansion, buy cars and other personal items, as well as to finance major expenditures such as vacations and college costs, brokers say. No one has precise statistics on what portion of the loans are going to which purpose, but industry experts estimate that roughly 5% to 10% of all margin loans now fund non-securities-related purchases.
How do margin loans work? You pledge the securities in your brokerage account as collateral, and the broker will lend you a portion of the account value. Often, the loan can be made within hours of requesting it. And the fees, if any, are generally reasonable.
While the loan is outstanding, you can still trade the securities that you’ve used for collateral, but you can’t take possession of them until you’ve paid off the loan. Additionally, if the stock in your portfolio declines in value, you may have to pay off a portion of the loan in a hurry--a “margin call.” If the stock value increases, you may be able to borrow more.
Why wouldn’t you simply sell a few shares instead of borrowing against them? That’s precisely what you should do if you think your stock portfolio isn’t going to appreciate more than the borrowing costs. But if your stock investments are likely to earn 15% a year, you’d be foolish to sell them to save 6.5%.
Additionally, it’s sometimes difficult to sell securities because of tax restrictions. If the bulk of your stock investments are in self-directed retirement accounts, for example, you can’t take the money out without paying taxes and penalties. But you can borrow against the account value without incurring these fees.
Each broker has different limits on how much to lend, but common practice is to allow customers to borrow up to 50% of the value of a stock account and as much as 90% of the value of their government bond portfolios.
There is generally no set repayment schedule. You pay off as you like, unless the value of your stock portfolio falls, when you may have to pay off the loan quickly to comply with the broker’s lending limits.
Here’s how it works: Let’s say you have a stock account worth $50,000 and want to borrow $25,000 to buy a car. If the broker allows a 50% margin balance, which is standard, you can borrow all $25,000 at the margin rate--probably about 7.5% now.
But if the value of your stock portfolio falls to $30,000, you’ll get a margin call--that’s your broker phoning to say you’ve got to pay off a portion of the loan, usually within five business days.
Margin calls are made when your equity--the difference between what your shares are worth and how much you’ve borrowed against them--falls below the broker’s “minimum maintenance” requirements. Minimum maintenance requirements vary, based on the broker and the type of account you have, but they’re all designed to ensure that you’ll pay up before the value of the broker’s collateral--your shares--evaporates.
Normally, you don’t have to pay back every dollar when you get a margin call. But you do have to pay enough to exceed the maintenance floor plus a little extra--enough to let your broker sleep nights. In this case, you’d probably be asked to pay $4,000 or $5,000. That’s a lot of money to come up with quickly.
For that reason, experts suggest that you use margin debt cautiously. It’s wise, for instance, to always keep your borrowings under the broker’s lending limits. If the broker allows you to borrow 50% of your account value, for example, you might want to limit your borrowings to 30% or 40% of the account value. That reduces your chance of a margin call.
It’s also important to note that the interest paid on margin loans is not tax deductible--unless the proceeds are used for a bonafide investment. Even then, the interest can only be deducted against investment income.
A Marginal Boom
The amount of margin debt has soared during the past two years, the result of both a bullish stock market and investors’ ability to finance purchases of everything from cars to household items with margin loans.
Year Margin debt (in millions) 1972 $7,900 1973 $5,050 1974 $3,840 1975 $5,390 1976 $7,960 1977 $9,740 1978 $10,830 1979 $11,450 1980 $14,500 1981 $14,150 1982 $12,960 1983 $22,720 1984 $22,470 1985 $28,390 1986 $36,840 1987 $31,990 1988 $32,740 1989 $34,320 1990 $28,320 1991 $36,660 1992 $43,990 June, 1993 $49,550
Source: New York Stock Exchange
