Initial Margin vs. Maintenance Margin: An Overview
Buying stocks on margin is much like buying stocks with a loan. An investor borrows funds from a brokerage firm to purchase stocks and pays interest on the loan. The stocks themselves are held as collateral by the brokerage firm.
The Federal Reserve's Regulation T sets the rules for margin requirements. There is an initial margin requirement, which represents the margin at the time of the purchase, and a maintenance margin requirement, which represents the minimum amount of equity in the total value of the margin account.
The initial margin must be at least 50 percent, according to Regulation T. If you want to purchase 1,000 shares of a stock valued at $10 per share, for example, the total price would be $10,000. However, a margin account with a brokerage firm would allow you to acquire the $1,000 shares for as little as $5,000, with the brokerage firm covering the remaining $5,000. The shares of the stock serve as collateral for the loan, and you pay interest on the amount borrowed.
Regulation T requirements are only a minimum, and many brokerage firms require more cash from investors up front. In this example, a firm requiring 65 percent of the purchase price from the investor up front would cover no more than $3,500 with a loan, meaning the investor would need to pay $6,500.
The benefit of buying on margin is that the return on investment can be greater if the stock appreciates in value.
Continuing with this example, imagine if the price of the stock doubled to $20 per share, and the investor then decides to sell all 1,000 shares for $20,000. If he bought it at a 65 percent margin, he'll need to repay the brokerage firm the $3,500 it loaned him, leaving him with $16,500 after an initial investment of $6,500. While the stock increased in value by 100 percent, the investor's $6,500 increased in value by more than 150 percent. Even after paying interest on the loan, the investor clearly is better off in this scenario than if he had purchased the shares with 100 percent of his own money.
The downside, of course, is that if the price of the stock drops, the investor will be paying interest to the brokerage firm in addition to being underwater on the investment, compounding his losses.
Once the stock has been purchased, the maintenance margin represents the amount of equity the investor must maintain in the margin account. Regulation T sets the minimum amount at 25 percent, but many brokerage firms will require a higher rate. Continuing with the same example used for the initial margin, imagine the maintenance margin is 30 percent. The value of the margin account is the same as the value of the 1,000 shares, and the investor's equity always will be $3,500 less than that amount since the investor must pay back that money regardless of how the stock performs.
So, if the price of the stock dropped from $10 to $5, the value of the margin account would drop to $5,000, and the investor's equity would be only $1,500, or 30 percent of the value of the margin account. If the price of the stock dropped to $4.99 or less, the value of the margin account would drop to a point where the investor held less than 30 percent equity, and he would receive a margin call from the brokerage firm. This means the investor would be required to deposit enough money into the account to maintain at least 30 percent equity.
The maintenance margin exists to protect brokerage firms from investors defaulting on their loans. Maintaining a buffer between the amount of loan and the value of the account lessens the firm's risk should a stock see a dramatic drop in price.
- A margin account allows an investor to purchase stocks with a percentage of the price covered by a brokerage firm.
- The initial margin represents the percentage of the purchase price that must be covered by the investor's own money.
- The maintenance margin represents the amount of equity the investor must maintain in the margin account after the purchase has been made.