Cash accounts are accounts in which investors deposit money and purchase securities. Margin accounts are accounts in which investors deposit money, purchase securities, while being able to borrow money against those securities.
What Is A Margin Account?
One important benefit brokers extend to investors is to lend them money using their securities as collateral. To take advantage of this benefit, the investor must have a margin account. In such an account investors can own an amount of securities that exceeds the account value.
The broker can monitor the status of the securities and the loan balance owed by the investor. Investors can use margin account borrowing capacity to purchase additional securities or even withdraw the money from the account (with certain limitations).
Margin accounts are also used by options investors who are required to put up collateral when shorting options.
Once an investor is approved for a margin account, there are no loan applications or other paperwork to complete. Investors simply purchase securities up to a limited amount and if they purchase more than the cash available in their account, the additional funds are automatically supplied by the broker (again, up to a certain maximum).
Investors are charged interest on the borrowed money, at prevailing interest rates, similar to a loan balance. There are, however, no loan payments required, unless the value of the securities falls below a certain amount. Otherwise, the debit balance simply remains in the account (accruing interest each month) and is automatically paid back when securities are sold or new money is deposited into the account.
Margin Account Requirements
Once an investor is approved for a margin account by their broker, there are several industry-wide requirements established for all margin accounts. The basic rules include:
1. Initial Margin
When initially purchasing common stock in a margin account, an investor must put up at least 50% of the stock's purchase value. In other words, the investor is required to have at least 50% "equity" in the position. That means the investor can purchase stocks worth up to twice the value of their available cash in the account.
Note: Initial margin is not the same for all securities. An investor can purchase US Treasury Bills with only 10% equity. On the other hand, options must all be purchased with 100% cash and cannot be purchased on margin at all. Options are already leveraged securities.
2. Maintenance Margin
If securities decline in value, the investor's equity in the account is accordingly reduced. Investors must maintain at least 25% equity in all existing positions. If the value of the collateral securities in the account falls to a point where the investor's equity is less than 25%, the broker will issue a margin call requiring additional money to be deposited to bring equity up to at least 25%. Failing to immediately heed a margin call can result in the firm liquidating some or all of the collateral securities to recover its balance owed.
3. Minimum Equity
Under any conditions, investors must maintain at least $2,000 of equity in a margin account.
4. Transfers
Securities cannot be transferred out of a margin account while there is a debit balance, since they serve as collateral.
Note: The rules above are minimums set by the SEC. Brokers can implement tighter rules if they elect to but must adhere at least to these minimums. As an example, a firm might have a maintenance margin requirement of 40%, rather than the required minimum of 25%.
How Do Margin Accounts Work?
Margin accounts essentially work just like ordinary cash accounts as far as buying and selling securities are concerned, but with higher purchase limits available to the investor. An investor with $5,000 in a cash account can only buy up to $5,000 worth of stocks, but in a margin account, they could buy up to $10,000 worth of stock with only $5,000 in cash.
If you have a margin account, your purchases use available cash first and then create a debit balance for the remainder, if necessary. Margin account order screens will usually tell investors how much "buying power" they have at any particular time. That informs them of what their maximum purchase amount can be, including borrowed funds from the broker. If an investor tries to buy stock worth more than the available buying power, their brokerage firm's order system will likely flag it and disallow the trade.
Tip: Margin calls are serious business. Brokerage firms maintain strict rules about how much time you have to deposit funds (usually the same day) before they sell positions to protect their interests.
Example Of How A Margin Account Works
Below is an example of a hypothetical margin account. An investor's account equity will always equal the total value of securities and cash in the account minus any debit balance. (The figures below do not include interest charged)
Investor deposits $5,000 in cash into a margin account Investor's equity: $5,000
Equity: 100%
Debit balance: 0 Investor purchases $10,000 of stock Investor's equity: $5,000
Equity: 50%
Debit balance: $5,000 Stock value rises to $12,000 Investor's equity: $7,000
Equity: 58%
Debit balance: $5,000 Stock declines to $9,000 in value Investor's equity: $4,000
Equity: 44%
Debit balance: $5,000 Stock declines to $6,500 in value Investor's equity: $1,500
Equity: 23%
Debit balance: $5,000
(Note - interest charges were not considered in the above example)
In this last instance, the investor would receive a margin call, as the equity in the account would have fallen below 25%.
Where & How To Get A Margin Account
U.S. and Canadian brokerage firms can all be expected to offer margin accounts. It should be noted, however, that their policies, such as approval criteria, account requirements, and the interest rate charged on debit balances, may vary.
When you are signing up for a new account, you will need to specify that you are looking to open a margin account. Firms will likely have additional questions for those applying for a margin account.
What Is A Cash Account?
Cash accounts are the default type of accounts at brokerage firms. They require that all purchases of securities be fully paid for with cash and that the cash is in the account prior to purchase. Securities in a cash account cannot be put up as collateral for a loan. New investors would be best advised to begin operating with a cash account before delving into margin lending.
How Do Cash Accounts Work?
Cash accounts require a cash deposit before securities can be purchased. There is no minimum cash or equity requirement in a cash account.
Long options positions (call options and put options) are allowed in a cash account with the appropriate option approval from your broker but uncovered option-writing positions or spread positions are not allowed in a cash account.
Cash Account Example
Cash accounts are very straightforward. The account holder's equity equals the total value of securities and cash in the account and the equity percentage is always 100%. There are no debit balances in a cash account.
Where & How To Get A Cash Account
All U.S. and Canadian brokerage firms will offer cash accounts, which will require you to simply fill out an account form. Cash accounts can exist with nothing in them, though orders to purchase securities cannot be entered until there are funds in the account.
Key Differences Between Margin & Cash Accounts
Cash and margin accounts are both used to purchase and hold securities. The main difference between them is that margin accounts allow the account holder to borrow money from the broker using the securities in the account as collateral, while cash accounts only allow you to use your own money present in the account. Specific differences are shown in the table below.
Margin Account Cash Account Requirements $2,000 minimum No minimum Leverage Risks Yes No Potential Returns Higher Basic Borrow against securities in the account Yes No Purchase options (with firm approval) Yes Yes Sell uncovered options or spreads Yes No Can have a debit balance Yes No
Source: Investor.Gov
Benefits Of Margin Accounts vs. Cash Accounts
Margin accounts offer investors several benefits over cash accounts:
- Margin account holders can purchase additional securities with money borrowed from the broker
- Margin account holders can borrow money against fully-paid-for stock in their accounts to use for external purposes
- Loans against securities in a margin account require no loan documents or approvals
- Investors can borrow temporarily against their account equity without needing to liquidate securities
- Investors are not charged to maintain margin accounts and can still purchase for cash if desired
Benefits Of Cash Accounts vs. Margin Accounts
- Cash accounts prevent investors from purchasing more stock than they can afford
- Cash accounts prevent investors from overleveraging themselves in emotional environments
Choosing Which Is Best For You
The best type of account for you is the account that best fits your style of investing and your attitude about investing with leverage.
If you do open a margin account, there is also no obligation to purchase on margin (using borrowed capital). You can use it just as you would a cash account and simply not purchase any more stock than you have money for.
Bottom Line
Margin accounts allow investors to obtain additional leverage and liquidity by using borrowed funds from their broker to purchase securities. If used, that leverage magnifies profit potential as well as loss potential and should be carefully considered.
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