By Geoff Hafer, Spring 2017 Student Intern
In the last edition of the five-part series “Opening Your First Brokerage Account” we addressed the question “Do I really know all the fees associated with my account?” Today, we will attempt to answer the question “Am I picking the right account type for my needs?” To begin with, most brokerage firms offer at least two types of accounts, a cash account and a margin loan account (known as a margin account).
In a cash account all transactions must be made with available cash and paid in full at the time of the purchase. When buying securities in a cash account, the investor must deposit cash to settle the trade or sell an existing position on the same trading day, so cash proceeds are available to settle the “buy” order. A margin account, on the other hand, allows an investor to borrow against the value of the assets in the account to purchase new positions. Although you must eventually pay for your securities in full, you are lent funds at the time of purchase, with the securities in your portfolio serving as collateral for the loan. This is known as buying securities “on margin.” The shortfall between the purchase price and the amount of money you put in is a loan from the brokerage firm, any just as with any other loan, you will incur interest costs.
There are risks that investors should be aware of when purchasing securities on margin that do not come with most other types of loans. For example, if the value of your securities declines significantly, you may be subject to a “margin call.” This means that the brokerage firm can either (1) require you to deposit cash or securities to your account immediately, or (2) sell any of the securities in your account to cover any shortfall. It is obviously imperative you fully read and understand your new account application and any other documents that your broker gives you concerning margin loan accounts. With some firms, you sign up for a margin loan account by default unless you indicate otherwise on the application. For more information about margin loan accounts, read FINRA’s Investor Alert, “Investing with Borrowed Funds: No ‘Margin’ for Error.”