Margin rate is the interest charged by brokers when traders purchase financial instruments like stock on margin and hold it overnight. It may also refer to a fee charged above and beyond the broker’s call rate.
In trading, it is common for a trader purchase shares of stock on margin which means they are borrowing money from the broker to purchase more shares than they normally would have been able to.
For example a trader has $2,000 cash but wants to buy a stock that will cost them $3,500, then they would borrow $1,500 from their broker to complete the purchase. Since the trader is borrowing funds on margin, they will pay interest on the borrowed amount just like you would if you borrowed money from your bank.
What you ought to know is that the broker acts as a lender and as such, the broker uses the funds in the securities account as collateral against the loans balance. Since the money was lent to the trader, the broker will proceed to charge interest rate. This is what financial experts refer to as margin rate.
Investors are known to select this method due to the anticipation of earning a higher rate of return from the investment.
Factors Affecting Margin Rate
Below we will go over some of the major factors that affect the margin rate.
Inflation – Inflation is the increase in prices which means products and services will be valued more than the legal tender (money). One of the leading causes of inflation is the availability of too much money in circulation.
As a result, the currency value is devalued. Inflation does affect margin rate which means the higher the inflation rate, the higher the margin rate. Financial experts have attributed the above phenomenon to the demand of higher margin rates by brokers and other lenders which acts as compensation for the decrease in currency value.
Supply and Demand – Margin rate levels are affected by supply and demand of credit. If there is an increase in demand for lending, it will raise the margin rates. When demand for lending decreases, the margin rate will lower. On the other hand, an increase in credit supply has been found to reduce the margin rate while a decrease supply of credit increases them.
Government Policies – The US Federal Reserve is known for making announcements regarding the monetary policy and how it will affect interest rates. You may already be aware of the federal funds rate or the rate that lenders charge each other when it comes to short term loans. This has been found to affect the interest rate against the money lent to borrowers.
The Federal Reserve uses open market transactions to influence the margin rate. How? When they (government) purchase more securities, lenders will have more money thus reducing the margin rate. If the opposite happens (government sells securities), money will be drained from lenders resulting in higher rates.
Final thoughts
Borrowing money from a bank or broker can help you invest more money into a stock which could potential increase your returns. Before borrowing, it is wise to research and find out the current margin rate charged by the lender. By doing this, you will ensure that understand how it will affect your profitability.