A brokerage margin account allows an investor to buy stocks and other securities with a portion of the purchase price paid with a margin loan from the broker. Margin loans can be a useful investment tool. Limits exist as to the size of loan an investor can have, and the account equity is used to determine those limits. Here's what you should know about how to use the equity margin formula and do some handy calculations that tell you whether you meet the requirements to increase the margin balance. However, it's essential to understand the term of the margin account and the conditions under which immediate payment may be required.
Buying Stocks on Margin
If you have a margin brokerage account, you can use a margin loan to pay up to 50 percent of the cost of buying stocks. For example, if you have an initial cash balance of $10,000, you can buy up to $20,000 worth of stocks. The 50 percent maximum margin balance for purchasing stocks is called the initial margin limit.
A margin loan offers you the benefit of being able to buy more stocks than your cash balance would allow. However, you'll find that the higher the margin balance you have, the riskier you're investing. That's because the margin loan comes with interest that you'll have to pay, and if you experience drops in the value to your investments, then you may end up dealing with both losses and the added interest to pay back for the margin loan.
Understanding the Equity Margin Formula
The equity in a margin account is the value of the investor's portion of the account; it is the investor's money. Equity is determined by subtracting the outstanding margin loan from the current value of the securities in the account.
In the example presented, say, after buying $20,000 worth of stock, the value of those shares increased to $22,000. The margin loan remains at $10,000, resulting in investor equity of $12,000. If the shares declined in value to $18,000, the investor equity would be $8,000.
Calculating the Equity Percentage
The equity percentage of a margin account is the investor's equity divided by the account value. In the examples presented, with $12,000 of equity divided into $22,000, the equity percentage is 54.5 percent. If the equity is at $8,000 and divided into $18,000, the percentage is 44.4 percent. If no new investments are made, the amount of the margin loan will stay level, and the investor's equity will change as the value of securities goes up and down.
Knowing Some Important Percentages
If the investor's equity is above 50 percent, the account has the ability to increase the amount of margin loan. The extra loan capacity can be used to buy more investments or can be withdrawn from the account as cash. A margin account also has a minimum maintenance margin. The Securities and Exchange Commission sets the maintenance margin at 25 percent, but a brokerage firm may set it higher.
If the equity in a margin account falls below the maintenance margin percentage, the investor will be issued a margin call to add cash or securities to the account to bring up the equity in the account.