How does a margin loan work?

A margin loan allows you to borrow money to invest by using your existing investments as collateral. Essentially, it leverages your investment portfolio to enhance potential returns but also increases the risk of substantial losses.

JL Collins provides a detailed analogy comparing margin loans with buying a house with a mortgage. If you buy a house with 10% down, the leverage magnifies your gains if property prices rise, but it also magnifies losses if they fall. This principle applies similarly to margin loans for stocks. If you invest using a margin loan and the stock prices increase, your returns are magnified. Conversely, if stock prices decline, the losses are also magnified, often forcing you to meet margin calls by selling assets, which can exacerbate market declines 1.

Unlike a mortgage, where the bank won't demand repayment as long as you make your payments, margin loans have margin calls. If the value of your collateral declines sufficiently, your broker can require you to deposit more funds or sell off assets to cover the loan, increasing the risk during market downturns 1.