You may be able to borrow money from your brokerage firm to pay for part of your investments. This is called buying on margin. Canadians have borrowed an average of about $10-billion on margin in the last two years. Before you decide, make sure you know how it works. Be ready for what can happen, both good and bad.
Did you know: You cannot buy on margin from a mutual fund dealer (a firm that only sells mutual funds).
Buying on margin: an example
Let’s say you have $1,000 to invest. Your brokerage firm agrees to lend you another $1,000 on margin. This amount equals 50% of the total you have invested. It is the most you can borrow for this type of investment.
Next, you invest the entire $2,000 in 200 shares of ABC Company at $10 a share. You agree to keep $1,000 in assets in your account at all times to cover this loan.
What happens next? Let's look at two scenarios.
Scenario 1: The stock rises to $12 a share
- You could sell the shares for $2,400 – a 40% return on your original $1,000 investment
- You would pay back the loan, with interest, and pay a sales commission to your broker
- After costs, your profit would be still higher than if you had invested without borrowing.
Scenario 2: The stock drops to $8 a share
- You will have a loss of $400 on paper. You could sell the shares and take your losses, or you could hold on to the shares in the hope that they may go up again sometime in the future
- You still have to pay commissions to buy the stock, plus the interest on your loan
- You will also have to put money back into your investment account. Why? Your brokerage firm is only allowed to lend you up to 50% of the total you have invested. This total is now just $1,600, down from $2,000. That means you can only borrow $800 on margin. Clearly, you are over your limit, because your current loan is $1,000. So, you will get a margin call to set it right. You’ll have to put $200 of your own money back into the account. You would also have to cover the costs of your trade. Learn more now
Remember: You can lose a lot of money very fast if you buy on margin.
Before you go ahead, it’s always a good idea to talk to an independent, trusted adviser. You may have many other options for investing your money.
Read Borrowing to Invest: Understanding Leverage, to learn more about borrowing to invest.
If you would like more information and practice with margin account principles, you may want to try the online Margin Account Simulation offered by the Investing Online Resource Centre. The website is funded by the North American Securities Administrators Association.
Content in this section is provided in partnership with the Investor Education Fund, a non-profit organization promoting financial literacy to Canadians. To find out more go to GetSmarterAboutMoney.ca.