Although stocks have been volatile lately, they have been attractive longterm investments. The broad U.S. stock market has returned approximately 10% a year for the past 25, 30, 35, and 50 years—and that’s still true after the bear markets of 2000–2002 and 2008–2009. If you have a long time horizon and can tolerate periodic slides, you probably should hold some of your portfolio in stocks or stock funds. Investors who can tolerate stock market risks may be able to enhance returns by investing on margin, or borrowing from their broker to buy securities using their own holdings to secure the loan. Assuming that stocks continue to rise, long term, margin investing can increase your exposure and your overall gains. You shouldn’t overlook the risks of margin investing, but you also should realize that tax advantages may push your investment results toward the plus side.
When you invest on margin, you borrow money to buy securities. Once you set up a margin account with your brokerage firm, the firm will lend you money, secured by your holdings there. Base interest rates on margin loans might be in the 6%–7% rangenow, but you can pay more or less if you have a small or large account with the firm. Interactive Brokers is notably cheap. Here is a cheaper firm
|DEBIT BALANCE||INTEREST RATE|
|$0 – $49,999||2.00% + 1.75%||(3.75%)|
|$50,000 – $99,999||2.00% + 1.00%||(3.00%)|
|$100,000 – $249,999||2.00% + 0.50%||(2.50%)|
|$250,000 – $499,999||2.00%||(2.00%)|
|$500,000 – $999,999||2.00% – 0.50%||(1.50%)|
|$1,000,000 +||2.00% – 0.75%||(1.25%)|
Typically, the maximum margin allowed on stocks is 50%. By borrowing, say, $50,000 on margin, you can buy as much as $100,000 worth of stocks. Then you’ll stand to gain or lose twice as much as you would if you had not invested on margin.
Where do the tax benefits come in? The interest you pay on a margin loan may be tax deductible (see the Trusted Advice column “Deducting
investment interest” for more information).
Example: Say you get a margin loan at a 6.5% interest rate, and your effective tax rate (federal, state, local) is 35%. With a 35% tax deduction,
your net borrowing cost is 4.225%: 65% of 6.5%. If your after-tax investment returns from the assets bought on margin top 4.225%, you’ll benefit from using the margin loan. Based on long-term stock market results, investing on margin can be a reasonable strategy for those who can
tolerate the risk.Moreover, the tax savings from deducting margin interest come right away. For many stock market investors, substantial taxes are deferred for many years, until they sell the shares, and favorable long term capital gains rates may apply. Although the numbers may seem favorable, don’t downplay the risks involved with investing on margin. If your investments lose value, you may get a margin call—a demand for more cash or securities in your brokerage account. If you don’t provide the cash or securities that your broker requires, the firm can sell securities from your account and use the proceeds for loan repayment.
One way to reduce this risk is to use less margin—20% or 30%, perhaps, instead of 50%. You’ll own less stock, but you’ll also have less chance of
receiving a margin call.