Margin Debt: What Is It & How To Measure It (2024)

What is Margin Debt?

Borrowing to invest can prove profitable so long at the returns from the investment exceed the cost of the debt. For example, if an investor borrows $10,000 at 5% interest, and invests it in Nvidia stock which they believe will rise 15% over the next year, the investor could stand to earn stock profits of $1,500 (15% of $10,000), while only paying $500 in interest, for a net gain of $1,000 ignoring taxes.

Margin accounts allow investors to borrow money from their brokers, using either newly purchased or existing shares of stock as collateral. In this manner, investors can initially borrow up to 50% of the value of their portfolio.

Margin debt doesn't not have to be drawn from a margin account; investors could, if they choose, take out a line of credit or another type of investment loan to fund their investments.

Margin Accounts

Investors can usually carry margin account debt indefinitely, so long as they have sufficient equity in their accounts to meet collateral obligations. They are even allowed to maintain the debt if the collateral shares decline in value, as long as they maintain this obligation. FINRA’s rule for stocks is that stocks can decline to the point where the margin debt is 75% of the total value of stock in the account. But individual brokers may be more conservative, allowing margin debt to only reach a maximum of 50% or 60% before requiring action from the investor to bring it back below the limit.

When margin limits are exceeded in any account, the investor receives a notification, deemed a margin call, to lower the margin debt immediately or risk liquidation. Lowering margin debt can be accomplished either by depositing additional funds or selling shares in the account to pay down the debt. When stocks invested in drop, the investor who borrowed on margin comes closer to receiving margin calls.

When stocks start to decline, those who are leveraged with margin debt may be forced to sell to meet margin calls and that could add to existing selling pressure, causing an even more severe decline.

The collective margin debt from all brokerage firms is tracked by FINRA and published monthly. If brokerage firms or regulators believe that there is too much outstanding margin debt, they can change the limits. While this is rarely exercised for overall margin, it is occasionally used for individual stocks that are deemed to be dangerously over-leveraged with investors.

What is a Margin Balance?

For any individual, the margin debt balance at any point in time is the outstanding balance owed to their broker in their margin accounts.

Margin balances do not have payments associated with them like a conventional loan. If an investor buys $10,000 worth of stock on margin by investing $5,000 of their own funds and borrowing the other $5,000 from their broker, that $5000 debt balance will remain there until it is paid down or you sell the stock. However interest will accrue on that debt at the broker's rate of interest.

What Can High Margin Debt Lead to?

Margin debt must eventually be repaid and that generally occurs through sales of the securities that served as collateral for the loan. When margin debt is high, falling prices on stocks can lead to margin calls, which in turn create even more selling. As such, general market declines can easily be exacerbated by the deleveraging that occurs through margin calls, sometimes leading to cascading declines such as in 2008.

Individuals are not the only ones who use margin debt to obtain leverage. Hedge funds are commonly leveraged with margin debt and some of the most dramatic hedge-fund failures were brought on by over-leverage. The most famous was Long Term Capital Management – the hedge fund created by several Nobel Prize-winning economists that imploded in 1998 with debts greater than $3.6 billion and had to be bailed out by a consortium of 14 banks under the direction of the federal reserve.

What Margin Debt Says About The Market Cycle

Margin debt tends to accumulate as prices rise and investors become more confident. Margin debt often climbs during the markup phase of the market cycle. Markup phases can vary in length and the current one has been going on for a decade. Long advances can breed complacency among investors who tend to remain leveraged well into the distribution phase, thinking they don’t need to sell until the market actually turns down.

Furthermore, the current advance in equities has been associated with the lowest interest rates in modern times, making margin debt seem all the more justified to investors. With rates as low as 2-3% per year for margin interest, an investor merely needs to make more than that to justify purchasing on margin. For many investors, that would seem like an easy target to beat.

Looking at the chart above, one can see that peaks in margin debt roughly coincided with the market peaks in both 2000 and 2008. While this cannot portend the next major decline, it suggests that there is at least a relationship between high margin debt and the distribution phase of the market cycle.

Current Aggregate Margin Debt & What It Means

From the chart above, there appears to be ample visual evidence that margin debt is highly correlated with the price level of the overall market. It often peaks and troughs at roughly the same times as those in the market. There is not, however, sufficient data to conclude that margin debt is a leading indicator of the market or whether it is essentially just coincident.

However, it does provide at least one data point that can be taken to support other indicators for a looming market top, such as market breadth, the number of new highs, etc. In addition, the level of margin debt could provide clues to the severity of subsequent market declines as it suggests that a great deal of additional supply will enter the market when it does turn and that much of it will be forced selling from margin calls.

Bottom Line

Margin debt is a sign of investor confidence and a measure of leverage in the market. By itself, it cannot be taken as a sure sign the market is necessarily about to peak. But it is certainly worth watching and, combined with other evidence, it can help validate where we are in the market cycle and potentially offer a clue as to how steep the next decline might be when it does come.