Now that you understand how a margin loan works, you need to find a margin loan provider. But what criteria do you use to compare providers? Are low margin rates the most important factor? Do you have the right type of securities to use in a margin loan? Are there other risks to consider? Below we’ve discussed factors for you to consider in further detail.
With the current Federal Funds borrowing rate near zero percent, margin loans are a very profitable source of revenue for large brokerage companies nationwide. If you ask your current broker or investment advisor what the going rate is, they may respond with rates as high as 8% or more. For many of these large institutions, much of this rate is all profit, which is why it’s important to shop the rate between custodians. Each firm sets its own margin rate and the amount of profit it wants to make for its margin program and from each client individually. Shopping the margin rate to other custodians can reduce these rates drastically. In today’s interest rate environment, it’s not uncommon to be able to find margin rates between 0.70% and 1.50% annually.
Each custodian will have different rules about acceptable securities to use as collateral for a margin loan. You need to understand them before making any commitment to move securities. Typically, custodians won’t lend against penny stocks or mutual funds whose share price may be under $5 per share. There can also be restrictions against lending on junk bonds or concentrated stock positions. Each custodian may have its own definition of a “concentrated stock position”, so it’s important to understand that. Some may conclude that 70% of the value of an account being in one security would be “concentrated”, when others may think 25% is “concentrated”. An investor should give their advisor a list of the securities they plan to use for collateral, fully understand what can be used as collateral, and if there are any restrictions.
Loan-to-value ratios should be understood before entering into any margin loan. Loan-to-value is a banking term which describes the amount that can be borrowed against a specific security. These ratios are ultimately regulated by the Securities and Exchange Commission (SEC), but each custodian may have more conservative rules. Typically the “safer” the security, the more borrowing power you would obtain. For example, a 90-day US treasury may allow for 90% borrowing power, while a blue chip common stock may only grant you 50% borrowing power. Banks will most likely give concentrated stock positions a lower borrowing power, because there is more risk of the value of your total account’s fluctuation from a single company event. In some cases, large blue chip stocks are given some of the same advance rates as a diversified portfolio, but this would be a question to ask if you were in this position.
Buffer levels, or maintenance values, are probably one of the most important things that you will want to know, because this relates back to the risk with securing a margin loan. If your securities fall a specified amount, the bank has the right to demand more securities or call in the loan. This would force a sale of the underlying securities at prices that may not be favorable to you. This action can also create unwanted tax burdens to the investor. As a result of this, you want to understand where these levels are and think about risk management strategies to protect your downside. Each custodian will have different rules about maintenance levels, so you will want to understand each of your securities and what maintenance level is required for your loan amount. Large cap stocks generally have a maintenance value of 30%. This means if you had $1 million of securities and a $500,000 loan, the value of the securities would have to fall to approximately $715,000 to trigger a maintenance call in which you would have to deposit more securities or pay down the loan. Bonds typically have higher maintenance values. Similar to advance values, you may find that concentrated stock positions have higher maintenance values because of the risk inherent in a single stock position. Additionally, certain mutual funds and junk bonds may have different maintenance values. Maintenance values are extremely important, and it’s surprising that more consumers don’t ask the correct questions about this. Understanding your risk is vital to a proper margin loan strategy.