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Are you a savvy investor looking to maximize your returns? Do you want to learn the main differences between a margin account and cash account to see which better fits your needs?
Deciding which type of account is best for you can be a challenge due to the range of options available. In this article, we’ll give you some tips on how to determine which type of trading account best suits your personal finance goals and objectives.
What is a Margin Account?
A margin account is a type of brokerage account that allows an investor to borrow money from their broker to purchase securities. In a margin account, the investor can leverage their investments to potentially increase their profits.
However, margin accounts can be high risk, as losses can exceed the initial investment due to the borrowed funds. Let’s say an investor wants to buy 100 shares of a stock that is trading at $50 per share, but they only have $3,000 available in their brokerage account.
In a regular cash account, they could only purchase 60 shares ($3,000 ÷ $50/share). However, if they have a margin account with a 50% margin requirement, they can borrow the additional $2,500 from their broker to purchase the full 100 shares.
The investor now has a margin loan of $2,500 in addition to their original $3,000 deposit. If the stock price increases to $60 per share and the investor sells all 100 shares, they would receive $6,000, resulting in a profit of $1,000 ($6,000 − $5,000).
However, if the stock price decreases to $40 per share, the investor’s losses would exceed their initial investment. In this case, the value of their shares would be $4,000, but they would still owe the broker $2,500, resulting in a loss of $1,500.
Webull and Robinhood are popular online brokerage firms that offer margin accounts to their clients. Both platforms allow investors to trade stocks, exchange-traded funds (ETFs) and options on margin.
Webull requires a minimum account balance of $2,000 to open a margin account and offers a margin rate that ranges from 3.99% to 6.99% depending on the amount you borrow.
Robinhood, on the other hand, does not require a minimum account balance to open a margin account and offers a flat margin rate of 2.5%.
Benefits of Margin Accounts
Here are some of the advantages of margin accounts:
- More buying power: A margin account provides investors with additional funds to purchase securities, resulting in increased buying power and the potential for higher returns.
- Line of credit: Margin accounts can function as a line of credit, allowing investors to access funds quickly and easily.
- Competitive interest rates: Margin accounts often offer competitive interest rates compared to other forms of credit, making them an attractive option for investors looking to borrow funds.
- Tax deductions: Margin account interest may be tax-deductible, reducing the overall tax burden on the investor.
- Profit from share declines: Margin accounts also allow investors to profit from declining share prices through short selling, where they can sell borrowed shares with the hope of buying them back at a lower price.
- Diversify portfolio: Margin accounts can be used to diversify an investment portfolio by allowing investors to access a wider range of securities.
- Repayment flexibility: Margin account holders have flexibility in how and when they repay their loans, allowing for greater control over their investments, which is an asset for beginners.
Risks of Margin Accounts
To fully understand how a margin account works, there are a few drawbacks to consider:
- Margin calls: If the value of the securities in a margin account drops significantly, the investor may receive a margin call requiring them to deposit additional funds or securities to meet the required margin level.
- Interest payments: Interest payments on margin accounts can be significant and must be paid regardless of whether the investment generates a profit.
- Reduced flexibility for future income: Margin accounts require investors to use a portion of their future income to pay back borrowed funds, reducing their flexibility in managing their finances.
- Can lose more than you borrow: Because margin accounts allow investors to borrow funds to invest, losses can exceed the amount of the initial margin investment, potentially resulting in significant financial loss.
What is a Cash Account?
A cash account is a type of brokerage account where an investor must have sufficient funds in their account to purchase securities. In a cash account, the investor cannot use borrowed funds to buy securities and must wait for their cash to settle before making additional trades.
Let’s say an investor wants to buy 100 shares of a stock that is trading at $50 per share. If they have $5,000 in their cash account, they can use that money to purchase all 100 shares.
Once the trade is executed, the $5,000 will be deducted from their cash account balance. If the investor wants to make another trade, they must wait for the first trade to settle, which usually takes two business days.
During that period, they cannot use the funds from the first trade to purchase additional securities. Fidelity and TD Ameritrade are examples of brokerage firms that offer cash accounts.
Both platforms offer a range of investment options, including stocks, bonds, and mutual funds, which investors can purchase using cash account funds.
Benefits of Cash Accounts
The advantages of cash accounts include:
- Better control over spending: With a cash account, investors can only spend their own money, which can help them avoid overspending or going into debt.
- Less risk: Cash accounts generally involve less risk than margin accounts because investors are not borrowing funds to invest.
- Ability to lend out money: Cash held in a brokerage account can often be lent out to other investors, providing the account holder with a source of passive income.
- No pattern day-trader (PDT) requirements: Cash accounts are not subject to the PDT rule, which requires margin account holders to maintain a minimum balance of $25,000 to make more than three day trades in a rolling five-day period.
- No risk of a margin call: Unlike margin accounts, cash accounts do not involve borrowing funds to invest. Therefore, there is no risk of a margin call, which requires the investor to deposit additional funds or securities to meet the required margin level.
Drawbacks of Cash Accounts
Some disadvantages can include, but are not limited to:
- Limit on profit opportunities: With a cash account, investors are limited regarding the amount of cash they have available to invest, which can restrict their ability to take advantage of certain profit opportunities.
- Settlement periods: Cash account trades take longer to settle, typically taking two business days, which can limit the frequency of trades that investors can make.
- No short selling securities: Cash accounts do not allow short selling, which is the practice of selling securities that an investor does not own with the expectation that the price will decline, allowing the investor to buy back the securities at a lower price and pocket the difference.
- Limited ability to futures trading: Cash accounts often have limited access to futures trading, which can limit an investor’s ability to diversify their portfolio. Futures trading involves purchasing or selling an underlying asset at a predetermined price and date in the future.
Cash Account vs. Margin Account: How do they compare?
|Cash Account||Margin Account|
|Limited to cash deposits||Ability to borrow money|
|Conservative risk||Aggressive risk|
|No PDT requirements||Risk of margin calls|
|Settlement periods||Interest payments|
Which is Better: Margin Account or Cash Account?
When it comes to deciding whether a margin account or cash account is the better investment strategy, there is no definitive answer. The choice between the two depends on an investor’s financial goals, risk tolerance and investment experience, among other factors.
- You have a high risk tolerance: Margin accounts offer the potential for higher returns through increased buying power and leverage, but they also come with greater risk.
- You have a solid understanding of the market: Margin accounts require a higher level of investment knowledge and experience, as they involve borrowing funds to invest. If you aren’t confident, you can work with a financial advisor for more info on investment accounts.
- You want to maximize your potential returns: Margin accounts offer increased buying power, which can allow investors to take advantage of more investment opportunities and potentially increase their returns.
- You have a low-risk tolerance: Cash accounts offer a lower risk than margin accounts because investors can only invest funds that are already in their account.
- You are a novice investor: Cash accounts are generally better suited for novice investors who are still learning about the market and want to limit their risk exposure.
- You prefer a more straightforward investment approach: Cash accounts offer a more straightforward investment approach than margin accounts, which involves borrowing funds to invest.
Still have a few questions about the differences between margin accounts and cash accounts? Check out the most frequently asked questions below.
Do day traders use cash or margin accounts?
Day traders can use both cash and margin accounts, but margin accounts offer more buying power and leverage for those looking to take on a higher risk.
What is the purpose of a margin account?
The purpose of a margin account is to allow investors to borrow funds from their brokerage to invest in securities and potentially increase their returns.
Can you ever withdraw cash from your cash account?
Yes, you can withdraw cash from your cash account, but it must be settled and available for withdrawal according to the broker’s policies and regulations.