Cash Account vs Margin Account: What's the Difference
When investors make a decision to trade securities, they also need to factor in what type of account they'll need. This can include a cash account or margin account from a brokerage firm. Both have benefits and disadvantages as well as potential limitations on what type of products can be traded.
Read on to learn more about a margin account vs cash account for beginners.
Cash Account vs Margin Account: The Main Differences
Cash accounts and margin accounts can be used by investors for different reasons. Both account types have their strengths and limitations that can provide a basis for investors to evaluate how they can help them meet their investment needs. Take a look.
Cash Account | Margin Account | |
Payments | Transactions must be fully paid with cash in the account | Transactions are paid with borrowed money or cash |
Leverage | No | Yes, there's a minimum margin requirement: For new purchases, the initial Regulation T margin requirement is 50% of the total purchase amount for marginable securities. There's also a $2,000 minimum net worth requirement in margin accounts to use this margin feature. |
Investments | Can trade stocks, bonds, ETFs, mutual funds, sometimes single-leg options transactions | Can trade stock, options, and futures contracts |
Risks | Have to pay for trades in full with cash balance | Margin calls, leveraging risk, and interest costs |
What is a cash account
A cash account is a type of brokerage account where investors must pay the full amount for the securities they purchase when using this account type. But first, they must have enough cash in their account to cover their entire trade on the same day that it trades so when the trade settles, there's enough cash available.
Cash is commonly deposited via ACH (an electronic, bank-to-bank money transfer processed through the Automated Clearing House (ACH) network). This usually takes two to three business days to settle in an account and be available for trading. This cash deposit needs to be settled before the trade settlement date to avoid an account violation.
How does a cash account work?
As we explained above, transferring cash into an account via ACH to cover a trade takes a few days to settle, so the investor should consider this timeframe as the settlement period for a buy order is typically T+1 (trade date plus one business day) to avoid potential account violations.
Unlike margin accounts, cash accounts don’t allow short selling or trading on margin. Investors can’t borrow against the value of their assets. Common violations on cash accounts to avoid include selling a security to cover a purchase made with unsettled funds (cash liquidation violation).
Investors must also avoid good faith violations, which means buying and then quickly selling a security before fully paying for the purchase with settled funds as well as free-riding violations which entail paying for a security with the sale of the same security.
How to open a cash account
Here's your step-by-step guide to opening a cash account:
Step 1: Choose a brokerage or online trading platform that you'd like to do business with.
Step 2: Typically complete an application online in under 15 minutes. Most states will require investors to be at least 18 years old to open an account, but some firms may allow parents to set up accounts for their kids, such as a custodial account or a teen-owned brokerage (investment) account.
Step 3: Fund the account by either depositing or transferring funds. This can be done through bank transfers, checks, or transferring assets from another brokerage firm.
What is a margin account
A margin account is a type of brokerage account that allows investors to borrow money from their broker to purchase securities, leveraging their investment capital. By using margin, investors can enhance their buying power, as they can buy more securities than they could with just the cash available in their account. The securities bought and the cash in the margin account serve as collateral for the loan.
How does a margin account work
In a margin account, the process begins when an investor opens a margin account and deposits a certain amount of money or eligible securities, known as the initial margin. This deposit acts as collateral for the loan. Note that the margin or "loan amount" isn't static. It will continuously vary based on the current dynamics of the account with regard to cash and securities within it.
Once the account is set up, the investor can then borrow funds up to a specified percentage of the total purchase price of the securities. This percentage is typically governed by regulatory requirements and the brokerage's policies, often around 50% for stocks. For example, if an investor wants to buy $10,000 worth of securities, they might be required to provide $5,000 from their own funds, borrowing the remaining $5,000 from the broker.
As the account is leveraged, the value of the securities purchased on margin can fluctuate. If the value of the securities falls, the broker may issue a margin call, which requires the investor to deposit additional funds or sell some of the assets to bring the account back to the required maintenance margin level. Failure to meet a margin call can result in the broker selling off the margin assets to cover the loan.
Margin accounts for short sellers
For short sellers, having a margin account is required by the Federal Reserve's Regulation T. With a margin account, there's an initial margin requirement of 150% of the short sale value in the account (the entire short sale proceeds (100%) plus the additional 50% margin requirement). For example, if an investor short-sells 1,000 shares at $10, the initial margin would be $15,000 ($10,000 proceeds + additional $5,000).
During the short sale's life, there's also the maintenance margin. If a position falls below this requirement, an investor faces a margin call and they may need to close the position or add funds to the margin account.
Currently, Financial Industry Regulatory Authority (FINRA) has set the maintenance margin at 25% of the total value of securities that is held in the trader's margin account, but brokerage firms may also have their own requirements, which are typically higher than 25%.
How to open a margin account
Here's a step-by-step guide on opening a margin account:
Select a brokerage firm: Research various brokers, comparing their margin interest rates, margin requirements, and customer service to find one that aligns with your investment goals and preferences. Or, consider opening one where your cash account is held.
Complete the application process: Often available online, the application will typically require you to provide personal information such as your name, address, employment details, and financial information, including your net worth and investment experience. This information helps the brokerage assess your suitability for margin trading.
Sign a margin agreement: This agreement outlines the terms and conditions of borrowing, including interest rates, maintenance margin requirements, and the broker's rights in case of a margin call. A margin agreement includes three parts:
Hypothecation agreement: Represents a contract between the customer and the broker-dealer that pledges the customer's securities as collateral for the loan
Credit agreement: Details the structure of the margin loan and how interest is calculated
Loan consent form: Allows the brokerage firm to lend out margin securities to other customers
Undergo an application review: Wait for the brokerage firm to review the application and margin agreement. If approved, set up your margin account and fund it with cash or securities to meet the initial margin requirement. This deposit acts as collateral for any loans you take out to buy securities on margin.
Risks of margin accounts and cash accounts
Margin account risks can include:
Losing more money than invested. With a margin account, the risk is that if the value of an investor's investments decline, they could lose more than initially invested, plus interest and commissions. For example, if an investor uses borrowed funds to half-fund their stock investment and the stocks decline by 50% or more, they could lose 100% or more of their portfolio. An investor may also have to repay the amount borrowed, plus interest.
Potentially needing to deposit additional cash or securities on short notice into the margin account to cover losses. A trader is not entitled to an extension of time for a margin call.
May be forced to sell either some or all of the securities when falling stock prices reduce the value of the securities.
A trader's brokerage firm may either sell some or all of their securities without consulting to pay off the margin loan. A trader is not entitled to choose which securities their brokerage firm sells in the account to cover your margin loan.
The brokerage firm can increase its margin requirements at any time, without a requirement to provide advanced notice.
Cash account risks can include:
Not having enough cash in your account for full payment of securities transactions on the settlement date. This can cause potential violations.
Only cash transactions are allowed; short selling or trading on margin is not.
Investment options are restricted by cash on hand in the account.
Positions in the account cannot be leveraged.
Margin accounts vs cash account: Which may be better for you?
Cash accounts may be a better option for beginners and investors with lower-risk tolerances, providing more opportunities to manage their cash but potentially offering more limited investment opportunities. In a margin account vs. a cash account, margin accounts can offer the potential for increased buying power and higher returns but also higher risks. These accounts may have greater appeal to more experienced traders with a higher tolerance for risk.