When signing up for a brokerage account, you may be asked if you’d like to open a margin account in addition to your cash account. If you’re not sure what this means, it’s critical to learn the difference between these two products before moving forward.
What’s the difference between a cash account and a margin account?
A cash account lets you buy securities such as stocks and bonds using only the amount of money you have, while a margin account lets you borrow money from your brokerage to buy more securities than you could with cash alone. The biggest difference between them is that with margin accounts, you can use the borrowed money to potentially amplify your returns, but you’ll also take on substantially more downside risk in doing so. With margin accounts, it’s even possible to lose more than your initial investment.
Here’s a more in-depth look at each type of account, and how they compare.
Cash accounts are probably what you think of when you picture a brokerage account, and they’re pretty straightforward. When you open a brokerage account, you’ll add money typically by transferring it directly from your bank, though you can also send a check.
Once the money is with your brokerage, you’ll probably have a few options: Some brokerages store cash in an investment called a money market fund, which offers small returns but greatly limits risk, and gives you access to your money whenever you need it. It’s not too dissimilar from a savings account, letting you use the cash when you need it, but generating more interest than a checking account. Other brokerages may use a range of other cash management solutions, such as a checking account that’s directly linked to your investment account.
But no matter how the brokerage manages the cash, the ultimate goal is the same: to let you invest that cash in the stock market. Once you’ve loaded cash into your brokerage account, you can then purchase whatever securities are best for your portfolio. Cash accounts won’t give you access to every security, but it’s still a fairly comprehensive list, including:
Publicly traded real estate investment trusts, or REITs.
Some options trades (depending on the brokerage).
For the typical investor, this list offers more than enough ways to build a strongly diversified portfolio.
If a cash brokerage account is like a debit card, letting you buy securities with only the amount of money you already have, then a margin account is like a credit card — you can buy securities with borrowed money, and pay the lender back later.
Make no mistake, trading “on margin” is an advanced trading strategy. While new, easy-to-use investment apps have lowered the mystique around margin accounts and made them far more accessible than they used to be, that doesn’t mean they’re appropriate for inexperienced investors. And if you’d rather put in place a hands-off, long-term investing strategy, margin accounts probably aren’t for you.
But if you are going to go this route, here are some important things to know before getting started:
Margin trading carries substantially more risk than cash accounts.
It’s possible to lose more than your initial investment.
You’ll have to pay interest on money borrowed from your brokerage.
If at any point you don’t have sufficient equity in your margin account, your brokerage can sell your securities on your behalf without telling you (more on this below).
Why would anyone use a margin account given these risks? One of the main reasons is the ability to magnify your investment returns. For example, if you have $5,000 in cash to invest in a stock, a 20% increase in the stock price theoretically means a profit of $1,000. However, if you borrowed an additional $5,000 and invested $10,000 total, that same 20% increase would result in a profit of $2,000 (minus interest), even after returning the borrowed money.
In other words, you doubled your profit with the same initial investment.
In addition to increasing buying power and adding leverage to stock trading, margin accounts give you access to additional securities and strategies. Generally, you’ll need a margin account to take part in:
Advanced options trades.
Comparing cash and margin accounts
In finance, leverage is often used to talk about the amount of money a company or person has borrowed. But it might help to think of the word’s origins in the world of physics.
Maybe you can’t move a boulder on your own. But with a long, strong metal pole and the right setup, moving that boulder becomes possible. Your strength is the same; you just used the concept of leverage to achieve an outcome that wouldn’t have been possible with your strength alone.
Through leverage in investing, the ability to take control of more shares than you’d be able to with your own cash opens up new possibilities for your investment’s performance that would otherwise be much harder, if not impossible, to achieve — much like moving that boulder.
There are, of course, some rules. First, as a regulatory minimum, you’ll need to deposit at least $2,000 with your brokerage, or 100% of the purchase price, whichever is less. Then, to get the loan, you’ll need to meet an “initial margin requirement” — a regulation that says you can only borrow up to 50% of the purchase price of the total investment.
So, if you want to buy $10,000 in stock, you could borrow 50% of that, or $5,000, and you would need $5,000 in equity — your account’s total value minus what you owe to the brokerage — in your account.
But the requirements don’t end there. After buying a stock on margin, you’ll have to keep a certain amount of equity in your account at all times, known as the maintenance margin requirement. The regulatory minimum requires investors to maintain 25% of the total market value of their securities in equity, but brokerages can and often do set higher minimums.
Let’s say you invest $20,000 in stocks, paying $10,000 in cash and $10,000 in borrowed money, and then the value of the investment falls to $16,000. You still owe the brokerage the full $10,000, so your equity is down to $6,000. If the maintenance margin requirement is 25%, you’d need to maintain a balance of $4,000 (25% of $16,000). In this case, you’re in the clear.
However, if the margin requirement is 40%, you’d need $6,400 in equity in your account, which you don’t have. Now you run the risk of a margin call, in which the brokerage can make you put more cash into your account to meet the minimum, or the brokerage may even sell your securities to make up the difference without telling you.
With a cash brokerage account, you’ll face the typical risks of buying any security. On a $5,000 stock investment, if the stock price falls 20%, your investment will have lost $1,000 in value.
With a margin account, your losses are magnified, just like your gains. So, if you had $5,000 to invest and you borrowed another $5,000 to buy $10,000 in stock, and the stock price falls 20%, its value will fall by $2,000.
Yes, margin accounts have the potential for higher returns than cash accounts, but they come with substantially higher downside risk. Even an investment that’s relatively stable most of the time can be rocked by unexpected and large price swings. And if you’re using leverage while that happens, it can spell disaster.
In Berkshire Hathaway’s 2017 letter to investors, famed investor Warren Buffett presented a table of some of the company’s largest price drops throughout history, ranging from about -40% to -60%. Why? To show that it can happen to any company, at any time.
“This table offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period,” Buffett wrote. “Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.”