What Is the Difference Between a Cash Account & Margin?
When you go online to set up a brokerage account, you are offered two types: a cash account or a margin account. If you look up margin account, you'll find a variety of heated opinions on the topic that may confuse more than clarify. Both cash and margin accounts serve different purposes, and the correct choice for you depends on your long-term investment goals.
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Cash Accounts
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Cash accounts are simple: if you have cash in the account, you can use it. Cash accounts are much like your standard checking account. You deposit funds to the account and use them to buy stocks, bonds, mutual funds and the like. You must have a cash balance large enough to cover your purchases, and the proceeds of sales are deposited back into your account when the trades settle.
Margin Accounts
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Margin accounts are like using your checking account in tandem with a credit card. Margin accounts can operate like standard cash accounts, but also have a line of credit attached to them. The cash and securities in your account act as collateral for your line of credit, and interest rates are lower than those for most credit cards. The credit in a margin account allows you to borrow money to buy shares---giving you more buying power, or leverage. Margin accounts also allow traders to borrow shares of stock to sell, a practice referred to as short-selling.
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Benefits and Drawbacks
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By far the biggest benefit to a margin account is the leverage provided by greater buying power. The more money you have at your disposal, the more you can buy and sell. The disadvantage of this is that you can get in over your head: a margin account is a loan, and a risky one at that. Not only can you lose your initial investment in a security, but you can lose the amount you borrowed as well. Cash accounts have less buying power, and are limited by the available cash at any given time. The advantage of this is that you can never spend---or lose---more than you have. Cash accounts are usually just fine for investors who take a long-term approach to their accounts, while margin accounts provide the flexibility needed for active trading.
Margin Requirements
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In certain circumstances, a margin account is required to participate in certain levels of trading. Brokerage firms require margin accounts to participate in short-selling and certain other practices. In addition, U.S. law requires pattern day traders to have margin accounts with specific levels of collateral. Pattern day traders are those that buy and sell the same security in the same day four or more times a week. This activity must account for at least 6 percent of the trader's activity during that week. Pattern day traders are required to keep at least $25,000 worth of cash and collateral securities in their margin accounts at all times.
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References
- eTrade.com; Help Center: Trade on Margin
- FINRA.org; Purchasing on Margin, Risks Involved with Trading in a Margin Account
- FINRA.org; Day Trading Margin Requirements: Know the Rules
- SEC.gov; Investor Tips: Margin -- Borrowing Money to Pay for Stocks
- "The Motley Fool"; Cash Account vs. Margin Account: What's the Difference?
