I saw a sexy advertisement from a brokerage firm bragging about its rock bottom borrowing rates.
"While the Fed is lending money at almost zero interest rates, why not take advantage of it? Our company will lend $1 million at 1.3% for every $200,000 in a portfolio margin account."
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Margin or "margin loans" allow you to buy additional securities by borrowing money from your broker and using the value of your brokerage account as collateral.
Here's an example:
Let's say you buy a stock for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you'll earn a 50 percent return on your investment. But if you bought the stock on margin - paying $25 in cash and borrowing $25 from your broker - you'll earn a 100 percent return on the money you invested. Of course, you'll still owe your firm $25 plus interest.
The broker's advertisement continued:
"See our high dividend scanner for the many hundreds of stocks that yield over five percent."
The problems of this strategy should be obvious. Even if you're borrowing money at 1.3% and getting a much higher dividend yield (NYSEARCA:PGF) from your stock investments, a lot can happen.
What if your stock decreases in value? For example, let's say the stock you bought for $50 falls to $25. If you paid for the stock with your own money, you'll lose 50 percent of your investment. But if you bought on margin, you'll lose 100 percent and that's not all. You still must come up with the margin interest you owe to your bookie, I mean broker.
There are a few more caveats.
Not all securities can be purchased on margin. That means you probably can't buy the 19% yielding penny stock your "genius" neighbor just unearthed.
Also, in volatile markets (NYSEARCA:VXX), investors who put up an initial margin payment for a stock (NYSEARCA:IVV) may, from time to time, be required to provide additional money if the price of the stock falls. What if you don't pony up the additional cash? The brokerage firm has the right to sell securities that you bought on margin without notifying you. And if your broker sells your stock after the price has plummeted, then you've lost out on the chance to recoup your losses if the market bounces back. Before opening a margin account, keep these facts in mind:
- You can lose more money than you have invested;
- You may have to deposit additional cash or securities in your account on short notice to cover market losses;
- You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities;
- Your brokerage firm may sell some or all of your securities without notifying you to pay off the loan it made to you.
Contrary to how they may be sold, margin accounts can be very risky. Even though they may appeal to sophisticated investors or those with lots of money, there are much safer ways to achieve higher income without putting your capital in front of a firing squad. So far this year, our Income Mix ETF Portfolio, has generated over $7,700 or 7.70% in annual income, using a portfolio of low cost ETFs. It doesn't chase yield and it doesn't leverage.
Remember: Trading on margin is only for people with a high tolerance for risk. Even if you're borrowing money at 1.3% dividend yields can be cut, stock prices can fall and borrowing rates can increase. Follow us at Twitter @ ETFguide