Understanding Margin Accounts

Ready to enter the world of stock trading? First you'll need to decide how you want to finance your purchases. When it comes to stocks, there are two ways to buy:

1. By paying the purchase price in full with funds available in your account
2. By using a margin account and borrowing to invest

What is a margin account and how does it work?

A margin account is a brokerage account which allows you to borrow money against the investments in your account.

Let's say you purchase stock in a margin account. As the buyer, you pay a portion of the purchase price and the broker lends you the difference. You pay interest on the broker's loan and it holds the security as collateral. Any income or interest earned in your account may be used to help offset the cost of borrowing.

The portion of the purchase price that you pay depends on the security. To learn more, see Eligible Securities and Applicable Margin.

The outstanding loan value is initially determined using the purchase price of the security. However, from that point on, the outstanding loan value is generally based on the market. This means that every day, as the value of your holdings and cash balance change in your margin account, the amount you are able to borrow against them will vary.

In a favourable (bull) market, this can be an effective strategy—but it can work against you in an unfavourable (bear) market. We explain more below:

Depending on daily market fluctuations, your account may either be in a “margin call," or margin excess (available credit) position. If the loan value, based on current market price, is less than the loan value extended to you when you purchased the stock (i.e. the stock price has dropped), you could be faced with a margin call. This is when a brokerage requires you to put up more cash against the loan to bring your account back to a margin excess position. You may need to place a sell order, deposit money or transfer in margin-eligible securities. On the upside, if the loan value is more now than at purchase (i.e. the stock price has risen), your account may have excess margin, which you can use for other purposes (to purchase more stock, for example).

Example: Let's say you had $10,000 cash in your margin account and used it to buy a Canadian stock that requires a 50% margin. Using your cash and a $10,000 investment loan, you can buy $20,000 worth of the stock. The following table shows what happens to your margin position if the stock price changes.

What about interest?

The interest rate charged on borrowed funds changes over time and depends on the account's debit balance. When you borrow funds to invest in income-producing assets in a non-registered account, interest costs are tax-deductible.

Canadian tax laws allow you to deduct the interest cost from the taxable income generated in your account (includes interest, dividends, business income and so on).

Key use of margin accounts

To borrow from the value your investments (leverage)

In contrast to buying an investment using 100% cash, leveraged investing enables you to borrow from the value of your existing investments to purchase a larger amount of stock and potentially generate a larger return, assuming favourable market conditions. And while you have to pay back the amount you borrowed, plus interest, your account gets to keep any investment earnings generated with the borrowed money.

Let's say you borrow to invest in stocks or mutual funds that have the potential to pay dividends or interest. The interest you pay on that loan may be deducted from the income earned, thereby reducing your borrowing costs. For instance, if you're in a 40% tax bracket and you borrow money at 7%, your after-tax cost of borrowing can be just 4.2% (i.e. 7% x (1 - 0.40).

Investing with borrowed funds may magnify returns—but it's important to keep in mind that it may also magnify losses, as shown in the table below.

Example: Borrowing funds can magnify returns and losses. This example assumes a $50,000 investment, 7% interest, a 40% tax rate, and a 15% gain or loss on your investment.

Weighing the risks

Leveraging investments may appear attractive, but you must be aware of the implications if the market conditions change from when you originally used your investment(s) to calculate your margin loan value. You could be faced with increased monthly loan payments due to increased interest rates, or a possible margin call if your account becomes under-margined due to a drop in market prices. Here are two things to consider when deciding whether leveraged investing is right for you:

Risk tolerance – What level of risk are you comfortable with? Will short term fluctuations in the market keep you up at night or do you have a long term investing horizon and feel comfortable with changing market values.

Cash flow – Do you have surplus cash handy to top up your margin account (if needed) or will fluctuations in borrowing costs or margin calls cause you financial strain?

To open your margin account

If you already have an RBC Direct Investing Cash Account and want add margin to the account simply download and fill out a Margin Agreement Form. Once you've completed and signed the form you can submit it online, drop it off at any RBC Royal Bank branch or mail it to RBC Direct Investing.

You can also open a new margin account by completing an Investment Account Application.

Is your information up to date? If you've recently moved or have a new job, you can easily update your profile by completing the Update/Change of Client Information form online.