How a Margin Account Works: Collateral, the Loan and Your Equity

A cash account is simple arithmetic. You deposit $15,000, you can buy $15,000 of stock, and the worst case is that the shares go to zero and you lose the $15,000. Nobody else has a claim on the account.

Switch on margin and a second party appears. The broker lends you money against the securities you hold, and those securities become collateral for the loan, which changes who gets to make decisions when prices fall.

What the margin agreement says

The agreement is long, and most of it is boilerplate. A few clauses deserve a slow read. They describe what the lender can do without asking you.

The broker may sell. If the account falls below the firm’s requirements, most agreements let the broker liquidate securities without notice, at a time and price it chooses, and pick which holdings to sell.

The broker may change the requirements. House maintenance levels can go up on a single stock or on the whole account, often without advance warning, and the new level applies to positions you already hold.

The broker may lend your shares. Securities bought with borrowed money can be lent out to other customers, usually short sellers who need shares to deliver, and the agreement calls this hypothecation or rehypothecation, which means your collateral can be pledged onward while you still own it.

The loan, and the first limit on it

The first cap on the loan comes from Regulation T and its initial margin requirement, which the Federal Reserve Board writes: on a new purchase of marginable stock you may borrow up to half the price, so at least 50% of the money has to be yours. Brokers can demand more.

In the example that follows, $15,000 of cash buys $25,000 of stock and the broker lends the other $10,000, which makes your share of the purchase 60% and keeps the loan at 40%, comfortably inside the federal limit.

Equity is what is left after the loan

Your equity is the part of the account that belongs to you. It’s the market value of what you hold, minus the loan.

Equity = market value - loan

The loan does not move with the stock. It stays at $10,000 whether the shares rise or fall. Interest is the exception, and it gets a lesson of its own. Every dollar the holding gains or loses lands on your equity alone, and that one fact explains most of what margin does to an account over a good month or a bad one.

Why a 12% move turns into 20%

Run the hypothetical account through a rise and a fall.

The stock moved 12% each way. Your equity moved 20%.

The ratio between them is the position over your equity: $25,000 / $15,000, about 1.67. Multiply a 12% move by 1.67 and you get 20%, and the multiplier works in both directions, so the same borrowing that makes a good month look better makes a bad one hurt more, and it grows as equity shrinks, because the loan stays put while the cushion under it gets thinner. The leverage ratio entry covers that multiplier on its own. The leverage calculator will work it out for any position you type in.

A cash buyer would feel 12% as 12%.

Where the arithmetic runs out

The subtraction has an end point. If the holding fell 60%, from $25,000 to $10,000, your equity would be zero, and any further fall would leave you owing the broker more than the account is worth, a debt that survives the sale of every share. A cash account can never lose more than was put in.

In practice the broker would step in well before zero. How early, and on whose terms, depends on the maintenance requirement, which a later lesson works through.

What a margin account does not change

The shares are still yours. Dividends still arrive and votes still count. Gains and losses are taxed as they would be in a cash account. What changes is who else has a say, and how fast a fall in the stock turns into a fall in the part of the account you own.

The loan also costs money every day it is outstanding. The next lesson puts a price on that, in dollars, over a day, a month and a year, and shows how unpaid interest raises the price at which the broker would call.