Effective Debt

Finance Allah shmoop what is a margin account I think

the bank of you you have one hundred grand in

stocks saved in a margin account set up at your

kindly loving Morgan Stanley or Schwab brokerage Lots of lawn

mowing and rich Uncle dying went into getting that hundred

grand Bessie Mae dies You need Bessie Mae two point

Oh the kind with round wheels this time Yeah she'll

cost twenty five grand You don't want to pay the

fifteen percent interest that the auto dealer offers you generously

loaning you the money And if you sell twenty five

grand worth a stock well you'll pay almost ten thousand

dollars in taxes so you'd have to sell something closer

Duff forty grand to net the twenty five grand after

tax And wow that's expensive for Bessie Mae Two point

Oh with the round wheels and air conditioning and windows

that actually work So you really don't wanna have to

sell stock The vastly cheaper solution is to borrow money

from yourself All right Well how do you perform this

magic Well your brokerage account is set up as a

margin account That is when you set it up You

checked and signed all the boxes that claimed you knew

what you were doing were of sound mind when you

signed and you realize that there's a fifty percent margin

limit on your account which is standard practice these days

So what does all that mean Well it means that

on your hundred grand of stocks in your brokerage account

you can borrow twenty five thousand dollars like tomorrow by

writing a check against it too dishonest Dean's discount dealership

and pay interest to Morgan Stanley or Schwab or whoever

has your brokerage account But you'll only pay about one

hundred basis points over prime rates or in today's world

three four percent if something like that nothing like that

fifteen ish percent egregious amount that the auto dealer would

want And this makes sense right when you're borrowing from

yourself If you ever don't pay yourself back while going

to be really easy to track down the deadbeat right

Morgan and Schwab happy to pledge or Chi pa Tha

Kate your stock to a bank and provide you whatever

cash liquidity you need by Bessie Tuo Morgan and Schwab

will pay maybe two percent or less on the money

They let you borrow for three percent or more so

they make a one ish percent spread for doing almost

nothing Nice work if you can get it And that

fifty percent margin limit thing Well what does it mean

Well let's say you've borrowed that twenty five thousand dollars

and weren't disciplined to pay it off And it just

sat there And then we had a really bad bear

market Like a mortgage crisis market that went down by

half or the individual stocks he loaned in there simply

went down by half And all of a sudden one

day you wake up and you have fifty thousand dollars

in change in the value of stocks in your account

Oh this is a problem Why Because if you don't

have atleast double in value in your account that money

you've borrowed the brokerage has the right to just sell

willy nilly Whatever assets you have to be certain that

you in fact keep it least double coverage right Why

Well they're letting you borrow money or at least borrow

liquidity at a very low price So they understandably expect

very low risk And if the market then goes down

another ten percent and your value is down to forty

five grand and you still have twenty five thousand dollars

in margin or borrow their well Then the brokerage can

and will immediately pick whatever stocks they want to sell

an anger behalf They will sell five grand worth of

stock just to get you to that magic half zone

So think about it There's a big big problem Why

they sell five thousand dollars worth of stocks to pay

down your twenty five thousand dollars of borrowing to then

be just twenty thousand Well in a margin account you

have forty grand now in value But those were stocks

that were gifted to you or maybe stocks you owned

a long time So now not only has the brokerage

soul chairs at a low price but you will owe

taxes on the gains from that five grand of sales

so you'll have to sell more shares down the line

to pay the kindly loving people of the I R

s bottom line Margin accounts are great if you manage

them and if you don't well yeah they end up

managing you