Author Topic: Explain this to me please  (Read 3018 times)

Gin1984

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Explain this to me please
« on: April 01, 2014, 12:27:19 PM »
In another thread someone posted this:
Quote
   Here's a crazy idea where you can have your cake and eat it too (as long as you have at least $10k):

 - Open up a brokerage account with Interactive Brokers.
 - Invest in a low-volatility ETF like XLP (consumer staple)
 - Request a margin account.
 - Borrow against the account to pay off your student debt.

Margin rates at Interactive Brokers are about 1.6% (lower if you have more than 100k).

You borrow at 1.6% to pay off a debt that costs you 6.8%.

Risk:  DON'T USE ALL YOUR MARGIN.  You should have a 50% cushion at least.  Even a bad scenario like 2008-2009 the value of XLP dropped 33% (and fully recovered in two years).  So assume a market crash - even if your collateral drops 33% in 6 months - you should have a 50% buffer to protect against a margin call.

Example:

Invest $10k
Margin is $10k
Borrow $5k to pay off debt

Even if the market crashed and your ETF dropped 33% to $6.7k - you'd still have enough to cover your margin.

You get to invest and pay off debt. 
Can someone explain how this works?  Others seemed to get it so I did not want to derail the thread.

sherr

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Re: Explain this to me please
« Reply #1 on: April 01, 2014, 01:43:13 PM »
Margin trading means that you pay a small fee to essentially borrow someone else's money to invest. http://www.investopedia.com/university/margin/

So you might be able to buy $10 worth of stocks after only putting in $1 of your own money, borrowing the other $9. This is great if the stock prices go up, if the value of everything is $15 when you sell then you can pay the lender their $9 back and keep $6 for yourself. Instead of a 50% return ($10 to $15) you have managed to make it a 600% return ($1 to $6). However if stock prices go down it's terrible. If stocks are at $5 when you sell, say, then not only did you completely loose your $1, you still owe the guy you borrowed from the other $4 that you have to give him from somewhere else. So in this example you've turned a 50% loss ($10 to $5) into a 500% loss ($1 to -$4). Margin investing is very high-risk.

What that guy is proposing is that you take $10k of your money and stick it in the stock market. You then would essentially be using it as collateral to borrow $5k to pay off your debt. Normally if you used $5k to pay of your debt and invested the other $5k then you get interest / losses on the $5k that you've invested. In this case you still have paid off your debt and have $10k gaining interest, but also have a $5k debt from borrowing on the margin.

The only reason you'd want to do it is because the interest rate from the $5k you borrowed on the margin is lower than the interest rate of your original debt. In his post he uses 6.8% for the original interest rate, and 1.6% as the margin interest rate. So in this particular case the investor would be saving 5.2% interest on his $5k debt, and adding to his life some additional risk of making a few more bucks if the stock market goes up or loosing a few more bucks if it goes down.
« Last Edit: April 01, 2014, 01:45:18 PM by sherr »

Gin1984

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Re: Explain this to me please
« Reply #2 on: April 01, 2014, 02:21:46 PM »
How soon do you have to pay it back, if you bought on margin? 

Spork

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Re: Explain this to me please
« Reply #3 on: April 01, 2014, 02:27:43 PM »
http://www.investopedia.com/terms/m/margincall.asp


...depends on how the market is doing.  If the stock tanks (you borrowed $10,000 for something that is now worth $5000) ... they might want (some of) that money right now.

Elwyn Bolstad

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Re: Explain this to me please
« Reply #4 on: October 10, 2014, 09:45:19 AM »
How soon do you have to pay it back, if you bought on margin?

That depends on your broker, but usually you do not have to pay it back until you face a margin call which means you do not have the funds required to hold your position any longer. This can be avoided through proper risk management. A lot of new traders often rush into trading without taking the time to proper educate themselves.  Margin Trading can be great for skilled traders, but the majority is likely to blow their account through a margin call. I recommend that you take the proper time to educate yourself first (I know this is an old thread, but new people often come across it just like I did and it makes the answer relevant for all new traders facing a similar dilemma).

This may help a bit as well http://upfx.com/margin-trading.html