how margin interest is calculated and charged

In short

A friend of mine once opened his brokerage statement and wondered why his balance had shrunk with no trades at all. The culprit was margin interest, a quiet charge that builds up each day a loan stays open. If you are holding a margin loan, the interest accrues daily and usually posts to your account once a month. The rate comes from the broker's own rate schedule, and it often drops as the loan grows. Each day's charge is the loan balance times the annual rate, divided by 360 or 365 days, whichever the broker uses. Interest adds to the loan, so it can start to grow on itself. Read your broker's margin disclosure before you borrow a dime.

The whole of it

What it is

I once watched a neighbor borrow against his truck to cover a roof repair, and he never once asked what the loan would cost by the end of the month. Most of us do the same when the money is handy. A margin loan is money a broker lends you, with the stocks and funds in your account held as collateral, which means security the lender can claim if the loan goes bad. The interest is the price of that loan.

You do not have to pay the interest by writing a check. Brokers commonly take it straight out of the account, either from your cash or by adding it to the loan. That is why the charge can slip past you. It is also why it deserves a close look.

Margin interest is not the same as the rules on how much you may borrow. Those rules cover the loan size. Interest covers the cost of keeping the loan open. Two different questions, and both matter.

How it works

If you have ever paid a car loan, you know interest is a rental fee on borrowed money. Margin works the same way, except the fee is figured every single day instead of once a month. Here is how a broker usually does it.

First, the broker looks at your loan balance at the end of each day. That is called your debit balance, meaning the amount you owe. Second, the broker finds the annual rate that applies to that balance. Third, it divides the annual rate by the number of days in its year, which is either 360 or 365. Fourth, it multiplies. The result is one day of interest.

Say a borrower owes $20,000 at an annual rate of 9 percent, and the broker uses a 360 day year. Daily interest is $20,000 times 0.09 divided by 360. That is $1,800 divided by 360, which is $5 a day. Over a 30 day month, the charge comes to $150.

Notice what the 360 day year does. A broker using 360 days charges slightly more per year than one using 365 days at the same stated rate. With 360 days, the borrower pays for 365 days of loan but divides by only 360. The gap is small. It is real.

Many brokers also use tiers. A tier is a band of loan sizes that each carry their own rate. A bigger loan often earns a lower rate. Some brokers apply the lower rate to the whole balance, and others apply it only to the slice of the loan that falls inside that tier. The disclosure document spells out which method the firm uses, and it is worth reading closely.

Then comes the compounding. If the broker adds the month's interest to the loan, the next month's interest is figured on a slightly larger balance. Interest on interest. It builds slowly, then more quickly the longer a loan sits.

The numbers, and where to find yours

You have probably seen a rate on a broker's website and wondered whether it was the one you would actually pay. Often it is not. The rate depends on your loan size, and many brokers build it from a base rate plus or minus a set amount. The base rate moves from time to time.

The legal limit that sets how much a person may borrow against a purchase is the current figure, which the official source publishes each year under the Federal Reserve Board's Regulation T. The minimum equity a broker must keep in a margin account is the current figure, which the official source publishes each year under FINRA Rule 4210, and a firm may set a higher bar of its own. These are loan size rules, not interest rules. Interest rates are not set by law. Each broker sets its own.

To find your own numbers, open your broker's margin rate schedule, usually listed on its pricing or margin page. Then open your monthly statement and find the line for margin interest or interest charged. The statement also shows your average daily loan balance, which lets you check the broker's math. FINRA, the industry regulator, and the SEC both publish plain investor guides on margin. Their pages on margin accounts are good places to confirm how the pieces fit together.

A worked example

Let me tell you about a woman named Dolores. She is a retired teacher who ran a small brokerage account, and she borrowed $15,000 on margin to cover a kitchen remodel while she waited for a bond to mature. Her broker charged 8.5 percent a year and used a 360 day year.

One day of interest was $15,000 times 0.085 divided by 360. That is $1,275 divided by 360, which is about $3.54 a day. For a 30 day month, the charge was $3.54 times 30, or about $106.25.

Dolores did not pay the interest in cash. Her broker added it to the loan. So her new balance after month one was $15,000 plus $106.25, or $15,106.25. The next month's interest was figured on that larger number. $15,106.25 times 0.085 divided by 360 is about $3.57 a day. Times 30 days, that is about $107.10.

The difference between $106.25 and $107.10 looks tiny. It is tiny. But stretch it across a year, and the loan she owes grows by more than the plain rate would suggest. After 12 months of added interest and no payments, a $15,000 loan at 8.5 percent grows to about $16,324 under monthly compounding, because $15,000 times 1.00708 raised to the 12th power is about $16,324. The plain interest alone would have been $15,000 times 0.085, or $1,275. The compounded growth is $1,324. That is $49 more.

Dolores sold the bond when it matured and repaid the loan after four months. Her total interest was about $430. She told me she was glad she had checked the numbers before the kitchen was finished instead of after.

Where it goes wrong

I have noticed that the costliest mistakes are rarely dramatic. They are quiet ones. Here are the common ones.

A borrower sees the headline rate and assumes it applies to the whole loan. The tier may differ. A borrower forgets that the rate can change, because many margin rates float with a base rate and the broker may adjust them without much notice. A borrower treats the loan as short, and then lets it sit for a year. Slow money. It adds up.

Another slip is ignoring the day count. The borrower must repay both the loan and the interest, and the broker may use 360 days where the borrower figured on 365. A borrower also overlooks that interest posts even when the market is closed, since the clock runs on calendar days, not trading days.

Then there is the risk that sits beside the interest. If the account value falls, the broker may issue a margin call, which is a demand for more cash or securities. The broker may sell holdings to cover it, sometimes without asking first. Interest charges can eat into the cushion, too. A loan that grows while the collateral shrinks is a squeeze from both sides.

Tax treatment is another place folks stumble. Interest on money borrowed to buy investments may be deductible in some cases, but the rules have limits and conditions. The Internal Revenue Service explains this in Publication 550, Investment Income and Expenses. A tax professional can say how it applies to a given person.

Questions to answer before you leave this page

Do you know the exact annual rate your broker would charge on the amount you might borrow, and have you found it in the broker's own rate schedule? Does the broker use a 360 day year or a 365 day year, and have you worked out what one day of interest would be in dollars? Is the rate tiered, and if so, does the lower rate apply to your whole balance or only to part of it? Will the interest be taken from your cash, or will it be added to the loan so that it compounds? How long might the loan stay open, and what would the total interest be at that length, written out with your own figures? What would happen to your account if your holdings lost value, and do you know what your broker does when a margin call goes unmet? And have you read the broker's margin disclosure from start to finish, including the part about changing rates?