Margin loans allows you to borrow against securities you already own to make additional investments

As with any other loan, margin loans do charge interest, which varies by the brokerage firm. Choreograph/Getty

• A margin loan is a type of interest-bearing loan that allows you to borrow against the value of the securities you already own in a margin account.
• Margin loans increase your buying power since you can buy more securities than you could using cash.
• While taking out a margin loan could increase your earning potential, it could also amplify your losses.

When opening a brokerage account, you have two options: cash account and margin account. If you decide to open a margin account, the amount you'll deposit into your account will act as collateral for the margin loan.

Here's what you need to know about what a margin loan is, how these loans work, and the pros and cons of using them.

What is a margin loan?

A margin loan allows you to borrow against the value of the securities you own in your brokerage account. Whether you have stocks or bonds in your portfolio, such investments act as collateral to secure the loan.

Each brokerage firm has its own terms on margin loans and what securities they consider marginable. Typically, they'll have a list of stocks, mutual funds, and bonds that are marginable. You can use margin to leverage your account as it will increase your buying power.

How do margin loans work?

Buying on margin occurs when you buy stocks, bonds, mutual funds, or any other market securities by borrowing money from a broker. "If you buy on margin, you will effectively be borrowing money from a brokerage to purchase stock,' says Baruch Silverman, founder of The Smart Investor. "In simple terms, you could think of it as a loan from a broker." When you buy investments on a margin, you're essentially using your securities as collateral to secure a loan. 

Most brokerage firms allow customers to borrow up to 50% of the value of marginable securities. So if you have $4,000 of marginable investments in your margin account, you can borrow up to $2,000. Using a margin increases your buying power because you can buy more securities than you could otherwise buy with a cash account.

Note: You don't have to borrow a margin loan of up to 50%. You can borrow less, say 10%, 20%, or even 30% based on your investing needs.

As with any other loan, "margin loans do charge interest," says Cliff Auerswald, president at All Reverse Mortgage. The annual percentage rate for margin interest is usually lower than that of personal loans and credit cards. Plus, "there isn't a set repayment schedule for everyone," he adds. Margin loans don't require a fixed payment schedule and any interest charged is applied every month.

Example of a margin loan 

Investors with a margin account can borrow up to 50% of the purchase price of marginable investments. Let's take a look at how that would work: Let's say you want to purchase $6,000 worth of shares in company X and have $3,000 in your brokerage account. You'd pay for 50% ($3,000) and your broker can lend you the other 50% ($3,000) for company X's shares. Your total purchasing power would then be $6,000, meaning you can spend up to $6,000 worth of marginable investments. 

A margin account can also allow you to borrow against your marginable securities you already own. For example, if you have $3,000 in marginable stocks and haven't borrowed against them yet, you can buy other investments worth $3,000 without having to add any cash into your account. The marginable securities you already own act as collateral for the first 50% ($1,500), while the newly purchased marginable investments provide collateral for the other 50% ($1,500). So you'd now have $6,000 worth of stock in your account with a 50% loan value.

Quick tip: Buying on a margin is a highly risky venture, especially for new, inexperienced investors. It's therefore advisable to start with a cash account before using margin.

Pros and cons of margin loans 

Using margin comes with several potential benefits, including:

• Increased buying power. A margin loan allows you to buy more investments than you could otherwise buy with a cash account. Let's say you want to purchase 100 shares of a specific company, but you have less money in your brokerage account. When you use margin, you leverage your account to buy more investments. 

• Easy access to funds. With a margin account, you can access cash without having to sell your investments. Your brokerage can give you instant access to funds, which you can pay back at your convenience by either depositing cash or selling securities.
• Allows you to diversify your portfolio. A margin loan gives you more buying power, meaning you can buy more different securities like stocks, bonds, mutual funds, and exchange-traded funds. A diversified portfolio translates to reduced risk investment.

• You can repay the loan by depositing cash or selling securities. Buying on a margin allows you to pay back the loan by either adding more money into your account or selling some of your marginable investments. 

• There's no set schedule for repaying the loan. The good thing with a margin loan is that you can pay back the principal at your convenience, provided that you meet your maintenance margin requirement.

As with any other financial tool, margin loans also come with drawbacks.

• You may face a margin call or liquidation of securities. Margin accounts have a minimum maintenance requirement, and if not maintained, you may be subject to a margin call. A margin call is an alert from your broker to load more money into your account, sell some investments, or add more marginable assets. If you don't meet a margin call, your broker can take prompt action to liquidate the securities in your account.
• Interest rates may rise. Margin loans charge interest but tend to have lower rates than other forms of lending. But, if you don't pay your margin loan interest for a long time, interest rates may rise, which can result in the cost of your loan increasing.

• You can suffer losses if the securities in your account decline in value. While a margin loan can increase your potential returns, the opposite is true 一 it can also magnify your losses. When securities in your portfolio decline in value, your losses go up. It's even possible to lose more than your initial investment.

The bottom line

A margin loan allows you to borrow against the securities you own in your brokerage account. Buying on a margin increases your buying power since you can purchase more investments than you could otherwise buy using cash. While margin can increase your potential returns, it can also magnify your losses. Plus, even if you're right with your trades, interest charges can eat up your profits.

Generally speaking, buying on a margin is highly risky, and you can lose more than your initial investment, especially if you're inexperienced. If you decide to take a margin loan, be sure to weigh the benefits and risks.