What Is Margin? Definition & Overview

KEY TAKEAWAYS

• Margin refers to the amount of equity that any form of investor currently has in their brokerage account.
• Buying on margin means using borrowed money from a broker in order to purchase securities.
• In order to buy on margin, you have to have a margin account. This is instead of having a standard brokerage account.

What Is Margin?

The term margin is a financial term relating to collateral. Specifically, it is the collateral that a particular investor has to deposit with their exchange or brokerage firm. This is in order to cover the credit risk if they were to borrow an amount of cash from the firm or the broker. The reason for this could be to buy financial instruments, borrow financial instruments to short sell them, or to enter into a derivative contract. 

When put into a general business context, margin can be explained as the difference between a service or product’s selling price and the cost of production. Essentially the ratio of profit to revenue. 

It can also refer to the portion of the interest rate on an adjustable-rate mortgage, or ARM, when added to the adjustment-index rate. 

How Margin Works

Buying on margin happens when an investor buys an asset through capital borrowed from the balance of a broker or brokerage firm. The term “buying on margin” refers to the initial payment that is made to the brokerage firm for the asset. The investor will use the marginable securities in their brokerage account as a form of collateral. 

A margin account is a brokerage account. This is where the broker lends an investor an amount of capital in order for them to buy more securities. An investor uses this margin to buy more securities than they would have been able to with their account balance. 

Using margin is essentially using the current cash or securities that you already have in your account as collateral for an individual or series of loans. The collateralized margin loan comes with a periodic interest rate. 

As the investor is using borrowed money, both the gains and the losses will be magnified. This makes margin investing advantageous when it comes to cases where the investor may anticipate earning a larger rate of return on the investment than the interest that they are paying on the margin loan. 

So for example, if you have an initial margin requirement of 40%, and you want to purchase $100,000 worth of securities, then your margin would be $40,000. You could then borrow the remaining balance from a broker. 

Uses of Margin

Apart from the use that we’ve highlighted above, there are two more main uses of margin:

• Accounting margin
• Margin for mortgage lending

Let’s take a closer look at both of these types.

Accounting Margin

When it comes to business accounting, margin refers to the difference between the business’s revenue and expenses. This is where businesses tend to track their gross profit margins, their operating margins, and their net profit margins. The gross profit margin measures the relationship that exists between a company’s cost of goods sold (COGS), and the company’s revenues. 

The operating profit margin takes COGS and operating expenses into account. It then compares them with revenue. The net profit margin takes all the expenses, taxes, and interest into account. 

Margin for Mortgage Lending

Adjustable-rate mortgages (ARM) work by offering a fixed interest rate for an introductory period of time. The rate will then adjust accordingly. In order to determine the new rate, the bank will add a margin to an already existing established index.

Most of the time this margin will stay the same throughout the entire lifecycle of the loan. However, the index rate will often change. In order to better understand this, imagine that a mortgage with an adjustable rate has a margin of 3% and is indexed to the Treasury Index. If the Treasury Index rate is sitting at 8%, then the interest rate on your mortgage is the 3% margin plus the 8% index rate. This means that it would be at 11%. 

Margin vs Markup

The difference between margin and markup can be explained when in relation to business accounting. 

Margin is equal to a business’s sales minus the cost of goods sold. Whereas markup is a product’s selling price minus the cost price. 

Margin Example

Let’s say that Investor X puts $10,000 into their margin account. It’s necessary to put up 50% of the purchase price, meaning you’ll have $20,000 worth of buying power. This portion of the purchase price is known as the initial margin. 

If Investor X was then to buy $5,000 worth of stock, they would still have $15,000 worth of buying power left over. 

This means that they have enough cash to cover the initial transaction, and they haven’t yet needed to tap into their margin. They would only need to start borrowing the money when they purchase securities that have a net worth of more than the initial $10,000. 

It’s important to note that the buying power of the margin account changes daily. This is depending on the movement of the stock price of the marginable securities that they have in the account. 

Summary

Margin is a useful way for investors to maximize their portfolios and obtain additional cash to purchase more securities on margin. This allows them to have more purchasing power than they can afford by themselves. Buying securities on margin compared to regular cash payments gives investors greater flexibility within the current market. 

The biggest risk when it comes to having a margin agreement is a decline in the value of the securities that have been purchased on margin.