The Perils of Margin Loans

Lured by ultralow interest rates and a recovering stock market, investors have rediscovered a risky investing tool: the margin loan.

Margin accounts, which allow investors to borrow against the value of the securities in their brokerage portfolios, hit $331 billion at the end of March, according to the Financial Industry Regulatory Authority, the brokerage industry's regulator. While still below the prefinancial crisis peak, that is up about 65% since the market bottomed out in 2009.

But their dangers were illustrated last week in a headline-grabbing margin call on the wealthy founder of Green Mountain Coffee Roasters (GMCR) . Still, it isn't just the super-rich who are amping up their leverage.

Many discount brokerages, which cater to smaller investors, report increases, too. At Charles Schwab (SCHW) Corp. and E*Trade Financial (ETFC) margin balances are roughly double their level three years ago, while at TD Ameritrade Holding Corp. (AMTD) they jumped 150%.

Another firm, Interactive Brokers Group (IBKR), has seen balances soar 367% over the past three years to $8.4 billion, attracting customers in part by running radio ads touting interest rates as low as 1.3%. "Traders sat out for a while," says Steven Sanders, Interactive's senior vice president of marketing. "Now they are saying, 'It's time to return.'"

But financial advisers say that borrowing on margin, while tempting for legitimate reasons, is often a dangerous move. When investors put borrowed money in the stock market -- the traditional use for margin loans -- it magnifies gains and losses. For example, by borrowing $50,000 against a stock portfolio of $100,000, and investing it back in the market, an investor boosts potential returns by half. If the market climbs 10%, he gains $15,000 (minus the cost of interest on the loan), rather than $10,000. But the losses would be just as large if the stock dropped.

That isn't the only risk. Investors who use the borrowed money for other purposes can get tripped up, too.

When banks or brokerages lend money against stocks or bonds, they keep a close eye on the value of those securities. If that value falls below a certain level, they issue a "margin call" asking the borrower to pony up more collateral. While investors typically get several days to comply, in an emergency, brokerages may cash out customers stocks with little or no notice in order to protect themselves.

That dynamic was thrown into sharp relief earlier this month when Green Mountain Coffee Roasters disclosed founder Robert Stiller sold $120 million worth of the company's stock in a single day to meet a margin call. Green Mountain shares had plunged by nearly 50% to $25 from $50 after a weak earnings forecast.

Green Mountain didn't respond to calls seeking comment. However, Mr. Stiller has said he used the borrowings to buy real estate, donate to charity and invest in other businesses.

Most advisers say borrowing on margin to amp returns should only be tried by sophisticated market players but some say margin loans can make sense as a tool for mainstream investors -- if they tread carefully. Atlanta-based financial planner Mitch Reiner says with interest rates at historic lows, margin loans can serve as a stopgap to help roll over other debt or as a way for a small-business owner to temporarily finance inventory.

He advises clients to keep loans short term, targeting, say, six to 18 months. They should also borrow no more than 10% to 15% of a diversified portfolio, he says, so they don't have to worry about getting squeezed. That way "the likelihood of a margin call should be slim to none," he says.