Is the receipt of investing income worth buying dividend paying stocks on margin?
Borrowing to Invest Doubles the Risk
Buying stocks on margin simply means that you borrow money from your brokerage to buy more shares of stocks than you have the cash for.
For instance, you have $5,000 cash in your account, but you want to buy $10,000 worth of stock.
You must apply to your broker for a margin account. This process is more complicated and longer to complete than opening up a simple brokerage account.
That's because you are applying for credit from your broker, so you're filling out a credit application just as much as if you're applying for a car loan or a Visa card. They want to make sure you have the financial capacity to pay them back.
They also want to know that you're reasonably experienced. If you're a newbie investor, you shouldn't be buying on margin. They also want to know if you're a good credit risk or not.
Brokerages can and do lose money to margin investors, but they don't like that and therefore try to avoid it. You can't blame them.
But if you do qualify, in the United States now you can usually borrow up to 50% of what's needed. That's called initial margin.
Therefore, if you want to buy $10,000 worth of stock but have only $5,000 cash of your own, but your application for a margin account is approved, the brokerage will lend you the second $5,000.
If the Stock Price Goes Down, You Get a Margin Call
Stock traders understand that when they buy on margin, they must see the stocks they bought go up in price, or the brokerage will be asking them for a margin call.
If the market price of the stock you buy goes down, then the total value of your portfolio goes down with it, and then the borrowed percentage of your portfolio goes up.
For example, if your stock sinks so that your portfolio's market value is now only $9,000, you still owe the brokerage the full $5,000. Therefore, the percentage is now 55.55%.
The brokerage may not sweat a small price dip, but they do want you to maintain a certain percentage, called the maintenance margin.
If the stock's market price continues down so that you're over the maintenance margin, the brokerage will issue a margin call. They'll want you to send them more cash. If you don't, they will sell off your shares of stock until your account goes below the maintenance margin.
If you don't wire them some cash ASAP, they have the right to sell off some of your stock whether you like it or not.
Income Investors Are Also Subject to Margin Calls
In my system of income investing, you buy stocks that pay dividends and hold them forever -- or until they stop paying dividends.
If you own a stock 100% free and clear, it's yours. The brokerage doesn't care what happens to the price. It's your stock, to do with as you wish.
However, when you buy on margin you aren't free to adopt that investing technique. If the market price goes down, you're not allowed to ignore it. You're subject to margin calls.
You Must Pay Interest on Borrowed Money
However, this money is not free. Just as with car loans and credit cards, you must pay interest to the brokerage to compensate them for lending you the money.
The interest rate can vary from brokerage to brokerage, and by how much of a credit risk you appear to be. It won't be the 25% that credit card companies charge their riskiest customers, but it won't be the prime rate either.
It will be higher than the 1.6% that the S&P; 500 companies currently, as a group, pay in dividend yield.
It will be higher than the 2.2% that the S&P; 500 companies that pay dividends currently pay, as a group, in dividend yield.
It will be higher than the 5-7% that Master Limited Partnerships, as a group, pay in distribution yield.
Initial Investing Yields Will Not Cover Your Margin Interest Expense
Therefore, if you are investing for income, you'll lose money by buying on margin.
If the market price goes down, you're subject to margin calls or to having the stock sold out from under you.
Even if the market price doesn't go down, you must pay the brokerage the interest you owe them. It's a terrible drain on your profits.
The conclusion is clear. When you are financing your retirement through investing income, don't buy stocks on margin.
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