Investing is an inherently risky venture, so to willingly add more risk to it is a particularly dangerous proposition. But investors often do that, feeling it gives them a better chance to profit.
One bit of risk that is common in investing is the use of a margin account - this is when the brokerage you open an account with gives you a loan to use for investments. Trading on margin gives you more capital to invest with, but it also makes you run the risk of a margin call.
A margin call has the potential to be catastrophic for investors, turning a poor investment choice into a much bigger issue. What is a margin call, what happens if you are unable to pay it and what should you do to avoid it?
What Is a Margin Call?
A margin call is what occurs when an investment incurs enough losses that the investor's margin account goes below a certain amount, known as the maintenance margin. When a margin call happens, the brokerage will demand add funds or securities to the margin account to get back over the maintenance margin.
The maintenance margin is often expressed as a percentage. With a margin account, the investor and the broker start off investing the same amount in securities. As the stock price rises and falls, naturally this changes. So the maintenance margin, as a percentage, is the minimum amount of the investor's equity that can be in the account.
The New York Stock Exchange (NYSE) requires a minimum margin of 25%, so this can be a common maintenance margin. A margin of 30% is also common, and it may be as far as 40%.
When the amount in your margin account goes down, so does the amount of equity inside it that is yours. The equity the broker gave is still in there.
For example, if a margin account has $100,000 in it, with you and the broker each putting $50,000 in, and then the securities' price drop causes the account to fall to $80,000, the broker's $50,000 is still in there. But your $50,000 investment fell to $30,000. Luckily, $30,000 is 37.5% of $80,000, so if your maintenance requirement is 30%, you won't face a margin call.
But if it falls below that number, the broker can alert you that they are issuing a margin call, and you will be required to bring the account back above the minimum required margin.
The margin call exists for brokerages to protect themselves and avoid substantial losses on their part. If the investment falls to a point that your account is below the minimum margin, they technically don't have to alert you of the margin call and can just start liquidating your assets to reach the threshold. But if you are seen as dependable and likely to add to the account and re-reach that threshold, you're likely to get an alert.
But that is important to remember, and why the risk of having a margin call issued is so dangerous to investors: the brokerage has no incentive to help you put money back into the account or give you time to find the funds. Their incentive is their own bottom line. So if you're faced with a margin call, the sooner you pay the better.
Margin Call Example
Let's say you want to invest in $250,000 worth of stock in a company whose shares are currently being sold at $100. You decide to open a margin account with a brokerage. You invest $125,000 into it, and so does the broker. The brokerage enforces a maintenance margin of 30%.
You thought this was a safe investment, but something bad happens to the company. Shares fall down to $70, bringing the amount in your margin account down to $187,500. Of that, $62,500 is your original investment, and is 1/3 of the amount in the account. An incredibly worrying decline, sure, but you are still above the requirement.
But the next day, shares keep falling and immediately hit $69. The account now has $172,500 in it. Now only $47,500 of that is yours, which is just 27.5% of the account. A margin call is issued.
How to Pay a Margin Call
Once this happens, you now have to deposit the necessary funds to get to at least 30% of that total, which would be $51,750. Your margin call is the difference between what is needed and what you have: 51,750-47,500 = $4,250.
Should you deposit the necessary funds, your amount of equity increases and the margin decreases, and for now the balance of the margin account is restored.
But what if you don't have $4,250 available to you immediately? You still need to bring the margin back up to its required minimum, or else the brokerage will start taking action. In a case like this, your best option is to start selling some of the stock in the account.
So in this specific instance, the margin account contains $172,500 and your equity is $47,500. We need to figure out how to bring the margin back to 30%, or .3. You don't have the funds to change your equity amount, so you'll need to sell from the margin. How much will you have to sell? Let's do some math.
(172,500-x) x 0.3 = 47,500
This is the equation we'll use to determine it, and it simplifies as such:
51,750 x 0.3x = 47,500
Thus, we need 0.3x to equal $4,250. That means dividing 4,250 by 0.3.
4,250/0.3 = $14,166.67
To bring yourself back to the maintenance margin you would have to sell off at least $14,166.67 of stock, creating a margin account with $158,333.33, $47,500 of which is your equity.
You may also consider selling other stocks you have to make the margin call, or selling other assets that could be valuable enough to help.
Consequences of Not Paying a Margin Call
If this happens to you, you're going to want to sell those stocks as soon as humanly possible. Trading on margin can make you look brilliant if you make gains, but substantial losses can turn into disaster. A margin call is a ticking time bomb, and your broker probably isn't going to give you an extension. They're just going to start recouping their losses.
If you can't pay your margin call, the broker will begin selling stocks and/or liquefying the assets in your account. The losses sustained in this period can then become debt you owe, meaning failure to make your margin call is just the beginning of the losses for the unlucky investor. If we use that $250,000 margin account from the above example, and that investor fails to make their margin call, suddenly they could sustain six figures of debt.
Being unable to pay back your debt to a brokerage can have massive consequences, depending on your situation. An investor with multiple accounts at that brokerage may have to sell the assets in those accounts to cover the debt. You may have to sell stocks and other securities you have from other brokerages just to cover the debt.
Struggling to pay back the growing debt could have major consequences on the entirety of your finances. The brokerage reports your debt to the various credit agencies, and your credit score is sure to take quite a hit. A poor credit score can hinder your ability to get approval for loans - including, if you somehow ever wanted to do it again, a margin account.
And even with all that damage, there's also the distinct possibility of a brokerage filing a lawsuit against you, taking up severe time and money.
So, yeah. Pay your margin call.
How to Avoid a Margin Call
The easiest way to avoid a margin call is to, well, not open a margin account. Buying on margin is one of the riskiest ways to invest specifically because of the way it amplifies losses when things go south. So if you want to avoid the hardships of a margin call, not opening a margin account is the simplest way to go.
But if you still want to open one, even if there are no guaranteed methods (you can't control whether a stock declines, after all) there are ways you can try to minimize the risk as best you can. Keep money and/or other easily liquefied assets available and saved for if you do face a margin call to avoid the aftermath of being unable to pay it. You could also, if you've noticed the stock declining before a margin call has been issued, add that saved-up money to the account and decrease the margin.
Another way to try and mitigate the risk of a margin call is to pick less inherently risky investments. Bonds don't have quite the growth potential that stocks do because they're far less volatile, but that lack of volatility also makes them less likely to fall as far as stocks can in a downturn market.
The most important thing for investors considering a margin account is to be aware. Going in without a ton of information just because it gives you more capital to invest with can be disastrous, but preparing accordingly in advance can help you do as best you can to prevent a worst-case scenario. Keep the risks in mind, keep some funds saved for if you need it, and stay constantly updated on how the investment is doing.
It's never too late - or too early - to plan and invest for the retirement you deserve. Get more information and a free trial subscription toTheStreet's Retirement Dailyto learn more about saving for and living in retirement. Got questions about money, retirement and/or investments? EmailRobert.Powell@TheStreet.com.