Margin accounts provide a new source of funds

Healthcare Financial Management, Jan, 1994 by William G. Kistner

With interest rates at their lowest levels in 20 years, the lending market has become as competitive as any other market segment of the U.S. economy. In addition to banks and credit card companies offering consumers cash, stock brokers are offering a product--the margin account--as a convenient, low-cost source of funds.

Margin accounts are not new. Historically, they have been used by investors to finance the purchase of stocks and bonds. An investor would buy a stock or bond "on margin" by using some of his or her own cash and borrowing the balance of the purchase price from a broker. The broker would hold the stock or bond as collateral. The competitive lending market, however, has caused brokers to offer these types of loans as a source of financing for purposes other than the purchase of stocks and bonds (education, home improvement, vacations, and so forth).

An investor obtains a margin account from his or her broker by completing a simple credit application. Once approved, the maximum loan limits are established by the broker, within the applicable regulatory limits. Generally, investors can borrow up to 50 percent of the value of stocks and convertible bonds and 70 percent on all other bonds except U.S. Treasuries, on which investors can borrow 90 percent or more. A variable interest rate, usually lower than what would be paid on a personal loan or automobile loan, is charged. Margin loan interest rates are usually determined by adding a premium to the "broker's call rate," the interest rate banks charge on loans to brokerage firms.

Margin accounts have no fixed repayment schedule. The value of the securities investors use as collateral, however, must continually satisfy the brokerage firm's "minimum maintenance requirement." The key test is the amount of equity in an investor's account after subtracting the outstanding loan balance from the market value of the securities held. An investor's account's equity level, expressed as a percentage of the market value of the securities in an investor's account, must at least equal the minimum maintenance requirement at all times. The New York Stock Exchange currently requires member firms to have a minimum maintenance requirement of 25 percent. Some firms set their requirements slightly higher.

An investor receives a "margin call" if the market value of the securities drops enough to bring his or her account's equity percentage below the minimum maintenance requirement. A margin call requires the investor to either deposit more cash or securities into his or her account. Otherwise, a broker may sell some of the investor's holdings to raise the equity level. Assume, for example, that an investor had 100 shares of XYZ stock worth $5,000 ($50 per share) in a margin account. If the investor borrowed $2,500, the equity of the account would equal 50 percent of the total value of the securities, well above the 25 percent minimum maintenance requirement. If the stock dropped below $33.33 a share, the investor would receive a margin call. Below this level, the equity in the investor's account would be less than 25 percent of the fair market value of the securities. For example, if the fair market value of the security dropped to $32 a share, the investor would have to deposit $260 cash or $520 in marginable securities. The margin call raises the equity in the account to 30 percent, slightly above the minimum maintenance requirement. This provides a small cushion in case the stock drops further.

If an investor can not raise the requisite cash or securities required by the margin call, he or she would be forced to sell the securities held as collateral, even though they have dropped in value.

Margin interest can be tax deductible to the extent that the loan proceeds are used for qualifying purposes--normally to purchase more investments or to invest in a business. A deduction for investment interest is limited to the amount of net investment income for the year. Interest on business loans may be limited, depending on whether the business is active or passive. To qualify for a tax deduction, investors must be able to trace the margin loan proceeds directly to a qualifying expenditure.

Careful record keeping is important to help investors show how they used the loan proceeds. It is best to keep separate accounts for investment and noninvestment purposes (consulting a tax advisor for more details on these rules is a good idea). Borrowing on margin to purchase, refurbish, or improve a residence will not produce deductible "residence" interest. To qualify as either acquisition debt or a home equity loan, the debt must be used for one of the reasons listed above and be secured by the residence.

William G. Kistner, CPA, is a tax partner with Ernst & Young in Chicago, Ill. Readers' comments and questions are encouraged and should be addressed to William G. Kistner, CPA, Ernst & Young, 233 S. Wacker Drive, Chicago, Ill., 60606.