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Understanding Brokerages, Cash vs. Margin Accounts

When you open a brokerage account to trade stocks or other securities, you have a choice between a cash account or a margin account. Understanding the difference is important for investors.

What is a Brokerage Account?

A brokerage account allows you to buy and sell investments like stocks, bonds, mutual funds, and exchange-traded funds. Some of the most popular brokerages that offer these accounts include Fidelity, Charles Schwab, E*Trade, and TD Ameritrade. When you open a brokerage account, you deposit money that you will use to purchase investments. The brokerage firm handles executing your buy and sell orders on the markets.

Cash Account

A cash account means you are only trading using the available cash you have deposited into your account. For example, if you deposit $1,000 into your brokerage account, you have $1,000 available to trade with. You need to wait until a trade settles before those funds are available again to trade. For stocks, settlement is 2 business days after the transaction. So if you use $500 to purchase a stock on Monday, that money will not be available to trade again until Thursday morning.

Benefits of a Cash Account:

  • Simple to understand - you are only trading the money you actually have deposited

  • No chance of owing money to the brokerage through trading on margin

Downsides of a Cash Account:

  • Need to wait for settlement of trades before reusing those funds

  • No leverage, so returns may be lower

Margin Account

A margin account allows you to borrow money from the brokerage to purchase securities, using your invested assets as collateral. This is known as trading “on margin” or margin trading. For example, if you have $5,000 cash but also have access to $5,000 margin, you effectively have $10,000 to spend on buying investments. However, you are still only putting up your own $5,000 - the other $5,000 is loaned to you.

Benefits of a Margin Account:

  • Ability to buy more stock than with just available cash, increasing potential returns

  • Flexibility if you need short term access to cash

Downsides of a Margin Account:

  • Interest charges on any margin loans from the brokerage

  • Forced sell risk - brokerage can sell your holdings to pay back margin loans if account equity falls below guidelines

For example, if you purchase $10,000 worth of stock using $5,000 cash and $5,000 margin and the investments quickly lose 50% of their value, the brokerage may force the sale of some or all shares to pay back the margin loan. This could mean locking in losses that otherwise could potentially have been recovered.

Margin Account Requirements

To open a margin account, your brokerage will review your credit history and income to set a maximum margin limit. Common margin requirements include:

  • Minimum account balance, often $2,000

  • Minimum credit score, often 625+

  • Income verification through tax returns or pay stubs

  • Existing assets with the brokerage can support more margin

For example, if you have a $15,000 account size, you may get approved for $5,000 margin even if you don’t meet all typical requirements.

Margin Interest Rates

One key cost to factor when trading on margin is the interest rate paid on margin balances. This interest is in addition to normal brokerage commissions for trading. Margin rates vary across brokerages but often track close to the broker call rate, which is currently over 8% at most firms. This rate can fluctuate over time. Make sure to check your brokerage margin rate so you understand this cost. For example, if you borrow $5,000 margin and hold that loan for 1 full year while paying 8% interest, you will pay $400 in interest charges.

Margin Maintenance Requirements

Brokerages allow margin accounts to fall to a certain percentage of total assets before issuing a “margin call” requiring the account holder deposit more cash or sell assets. This limit ensures client accounts have enough equity to support the margin loans being extended. A typical margin maintenance requirement is 30%. This means if your account assets fall below 30% equity due to declining investments, you will get a margin call. For example, if you have $10,000 in invested assets and a $5,000 margin loan, you have $5,000 equity against the total $15,000 holdings, which is a 33% equity percentage ($5,000 / $15,000). If your holdings decline to $12,000 total while the margin loan remains $5,000, your equity is now $7,000 out of $17,000 total - only 41%. This would trigger a margin call from the brokerage.

Understanding these requirements allows investors to appropriately size margin usage and maintain sufficient equity buffers.

Cash accounts are simpler but limit your buying power, while margin accounts offer leverage at the risk of interest and forced sells if investments decline. Evaluating your risk tolerance is important in deciding which type of account makes the most sense.

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