When you apply for a new brokerage account, one of the first choices you need to make is whether you want a cash account or a margin account.
Online brokers offer two types of accounts: cash accounts and margin accounts.
Both allow you to buy and sell investments, but margin accounts also lend you money for investing and come with special features for advanced investors, like short selling.
With a cash account, you can only invest the cash that you have deposited in your account. Margin accounts extend you a line of credit that lets you leverage your cash balance. This extra complexity can make them risky for beginners.
How Does a Cash Account Work?
A cash account allows you to purchase securities with the cash in your account. If you’ve deposited $5,000, for example, you can purchase up to $5,000 in securities. If you’d like to buy more, you have to deposit additional funds in your account or sell some of your investments.
Notably, with a cash account, your potential losses are always capped to the amount you invest. If you invest $5,000 in a stock, the most money you can lose is $5,000. For this reason, cash accounts are the better choice for new investors.
How Does a Margin Account Work?
With a margin account, you deposit cash and the brokerage also loans you money.
A margin account gives you more options and comes with more risk.
You get additional flexibility to build your portfolio, but any investment losses may include money you’ve borrowed as well as your own money.
You are charged interest on a margin account loan. Margin loans generally have no set repayment schedule.
And the securities you buy in a margin account serve as collateral for your margin loan.
Before you start buying on margin, you must make a minimum cash deposit in your margin account. FINRA mandates you have 100% of the purchase price of the investments you want to buy on margin or $2,000, whichever is less.
Once you start buying on margin, you are generally limited to borrowing 50% of the cost of the securities you want to purchase. This can double your purchasing power: If you have $5,000 in your margin account, for example, you could borrow an additional $5,000—letting you buy a total of $10,000 worth of securities.
After you’ve purchased securities on margin, you must maintain a certain balance in your margin account.
This is called the maintenance margin or the maintenance requirement, which mandates at least 25% of the assets held in your margin account be owned by you outright. If your account falls below this threshold, due to withdrawals or declines in the value of your investments, you may receive a margin call.
What Is a Margin Call?
A margin call is when your brokerage requires you to increase the value of your account, either by depositing cash or liquidating some of your assets.
Margin calls occur when you no longer have enough money in your margin account to meet maintenance margin, either from withdrawals or declines in the value of your investments.
The Benefits of a Cash Account
In addition to giving you the flexibility to invest for long-term growth, buying with cash creates a floor for your losses. Whether in a cash or margin account, investments purchased with cash will only ever cost you the amount you invest.
The Benefits of a Margin Account
While buying on margin can be risky, opening a margin account has certain benefits. There are generally no additional fees to maintain a margin account, and it can be really useful for short-term cash flow needs.
If you need cash from your brokerage account in a hurry, your brokerage can give you instant access to cash through a margin loan, which you can back with a cash deposit or by selling securities.
Should You Open a Cash or Margin Account?
A cash account will meet the needs of most basic investors.
If you’re a novice investor, there’s little reason to venture into margin trading.
You need a margin account in order to sell stocks short, also known as short selling. With this speculative trading strategy, you profit from a decline in a stock’s price.
Like buying on margin, short selling is a sophisticated strategy for advanced investors.
Although trading on margin is risky and only for the sophisticated investor, having a margin account that you can use for short-term cash flexibility can give you the best of both worlds.