A brokerage account is an investment account, also known as a financial or taxable account. Setting up a brokerage account is very easy, as it hardly takes 15-20 minutes to complete the application online. It help you buy or sell stocks, mutual funds, and bonds and provide security in the stock market. There are no contribution limits or early withdrawal penalties in brokerage accounts, making them restriction free.
There are many types of brokerage accounts out there, but these two options help meet the demands of the majority of investors: robo-advisors and online brokers. Brokerages offer different varieties of accounts to investors based on their needs. It can be a full-service, self-directed, discount, cash, or margin account. The main difference between cash account vs margin account is, in a cash account you can sell or purchase securities with cash available in your account. On the other hand in a margin account, you can lend money from brokers and use them in investments
Cash Account Explained
1. Definition and Functionality:
In a cash account, you can sell or purchase stocks and other investments with the cash available in your account because cash accounts do not allow borrowing money from brokers. You can only use available cash in your account for trading. In this case, any dividends or interest earned from trading will be added directly to your cash account. You can easily transfer or withdraw from a cash account to your bank account or any other brokerage account, and you can manage your account by checking your account history.
2. Advantages of Cash Accounts:
- With a cash account, the risk is reduced because you can only withdraw the amount that is currently in your account; for example, if you have $5,000, you can only lose $5,000. The amount of loss is limited, as you cannot lose more than your initial investment.
- If you are a new investor, then a cash account can be your thing because it is simple to start with. As opening a cash account does not require any borrowing or interest on your borrowed funds. Thus, you can easily manage these accounts,and the experience you get here is a bit more relaxing as compared to a margin account.
- Apart from these benefits, there is one more benefit to having a cash account. When you open a cash account, it is not subjected to pattern day trading rules, and there is also no need to worry about the margin interest in a cash account. Because here you are, you are using your own funds for investment, so you can save your money on interest.
Margin Account Explained
1. Definition and Functionality:
A margin account is a type of brokerage account in which a broker lends money to traders so that they can purchase stocks, mutual funds, and other investments. In this account, investments work as collateral for loans, and to keep the account active, traders have to pay interest on a regular basis. Margin accounts provide more buying power to investors, which helps them in big investments and trading, but this also means that big risk chances are there.
The main difference between a cash account vs margin account is the amount of borrowed funds used. In a cash account, investors can only use the amount present in their account for purchasing securities; they are not allowed to borrow money from brokers. Whereas, in a margin account, investors can borrow money from brokers for investment and use that money to purchase securities up to a certain percentage of the total value of eligible securities mostly present in the account.
A margin account gives more chances for benefit because of leverage, but with that, it's more risky than a cash account. To boost their trading, investors have to open a margin account with their brokers through which they can borrow money from their brokers with the help of margin trading which allows them to invest in bigger positions than the actual amount they borrowed. But should also remember the risk factors of a margin account.
2. Leverage and Risk:
Leverage refers to the concept where investors can use borrowed money to increase their potential growth instead of using their own funds. When investors get this opportunity to invest more than their actual money, it can increase their gains as well as losses.
If things go according to plan, leverage can prove beneficial to investors. But if things don't go with the plan, there's also a risk of losses.
Margin trading allows you to use brokers' money to invest in stocks and other investments and provides you more buying power. It provides you more benefits than that traditional trading, but also comes with more risks comparatively. Purchasing stocks on margin trading can increase risk and lead to margin calls. Margin calls are reminders by brokers to keep your account active Whether by selling stocks or by managing.
Margin trading is risky because you have to pay interest on borrowed money in case of profit or loss. It can be beneficial to purchase from a margin account but leverage can be the reason for loss and risk. If the investor does not have sufficient equity in their account, brokers can sell their securities without waiting for permission from you.
Please pay attention that margin trading and leverage are different things. Margin trading Is a method where you can invest through lending. while leverage is a method where investors use borrowed money to increase their potential earnings.
3. Margin Requirements and Interest:
Margin accounts require you to maintain a minimum amount of money in your account; if you are unable to do so, you won't be able to borrow stocks or make other investments from a broker. Your broker will confirm the amount and rules, and this will determine how much of your stocks you can keep in your own account.The amount you can borrow totally depends on this factor. As the money you deposit in your account increases, it will influence your borrowing amount.
Margin interest rates are those rates you need to pay when you do trading with the help of borrowed money. These rates affect trading expenses, if these rates are high, borrowing for trading becomes more expensive for investors and if they are low then trading from borrowed money becomes less expensive. If you want to make money on trading, It is important for traders to understand these rates and carefully examine its effect while trading on margin.
Key Differences Between Cash and Margin Accounts
1. Source of Funds:
In a cash account, funds used for trading are restricted by the cash amount present in the accounts of investors. Whereas, in a margin account, traders, besides their own capital, can also use borrowed money from brokers for trading, which provides them with big trading position opportunities.
2. Trading Limits and Flexibility:
In a cash account, trading limits are lower because investors can only use existing cash from their accounts to purchase stocks. Leverage is not used in cash accounts. That's why trading positions are smaller compared to those in margin accounts. With that, short selling and Intraday leverage features are also limited in cash accounts.
In a margin account, there is more flexibility in trading and traders can use their money as well as borrowed money from brokers to raise funds which provides opportunities for big positions. Features like short selling and leverage are available in margin accounts but these come with high risk because investors had to pay the interest on borrowed money.
3. Risk Management:
In cash accounts, risk management tends to be more conservative as investors can only use their own capital for trading, which is why the threat of losses remains limited to available cash. In this situation, people tend to be careful regarding their investment decisions so that they can save their capital. Profit can be lower in cash accounts; however, the risk remains lower as no borrowing is involved in cash accounts. This results in their investment decisions as it generally tends towards lower risk and long-term perspective
Investors can use borrowed money for investments in margin accounts, which increase their investment positions. But this also increases the risk. If the investment price goes down, investors can face margin calls, where they might need to deposit extra funds so that they can cover the loss. In such accounts, the possibility of risk is greater because you have taken a risk on both the initial investment and the borrowed money. A margin account is good for experienced investors who can manage leverage nicely and who know how to manage risks.
Factors Influencing the Choice of Cash account vs Margin account
Factors one must remember before investing in these accounts include risk tolerance, market conditions, goals, and strategy.
1. Investment Goals and Strategy:
Different investment goals match better with different types of accounts.
Investors with lower risk tolerance who prioritize stability and want to safeguard their capital.
A cash account can be a good option for them. However, if you are an experienced investor who can manage risk well and aim for higher growth potential, margin accounts can be good choices for you.
2. Risk Tolerance:
Investors' risk tolerance significantly affects their investment decisions. If you are well aware that lending involves risk and the chance of potential losses, and if you have a high-risk tolerance, you can go for a margin account.
But if your risk tolerance level is low and you don't want to risk your funds, you can opt for a cash account.
3. Market Conditions:
Market conditions, especially trends and volatility, can impact this choice of account type. A margin account can be riskier in a volatile market because of its quick and unpredictable nature. Fluctuations in prices may lead to potential losses. In this condition, investors can choose a cash account. Whereas for bullish trends, when there is an upward movement in prices, investors should go with a margin account to increase their investment and for potential growth.
Case Study of Cash account vs Margin account
Let's say you are an investor who wants to invest for a longer time, and you believe that XYZ companies are going to grow and the price of shares may increase. So you opened an account with a brokerage company where you would keep your money. Suppose you deposited $30,000 in an account. Now you will use this money to buy shares of the companies directly; that means you are purchasing shares using your own money without any borrowing. As time passes, if the price of your share increases, the value of your money will also grow, and any profit you make will belong entirely to you. You don't have to stress about loans, and you have full control over your investment.
Imagine yourself as a trader who trades frequently in the stock market and wants to take advantage of short-term movement in the stock market. You have opened a margin account with a broker and deposited $10,000 into it. In a margin account, through borrowing, you can increase your trading power. Now, suppose you've noticed an opportunity for the price of Company B's shares to increase, and you've decided to not only use your $25,000 but also leverage margin to buy $40,000 worth of shares in Company B. This means you have landed $15,000 from the broker.
Now if the share price increases, then you will benefit too, but if the share price goes down, you also have to face the downfall in prices, and if the initial investment value decreases, you might need to borrow money.
Detailed comparison of Cash account vs Margin account:-
|Only uses available cash
|Allows borrowing against securities
|Limited to available cash balance
|Can exceed available cash through margin
|Allows borrowing for trading
|Limited or not allowed
|Allows short selling
|Lower risk due to no borrowing
|Higher risk due to potential leverage
|No interest charges
|Charged interest on borrowed funds
|There is no minimum equity requirement
|Requires maintaining minimum equity
|Can trigger a margin call
|Limited by available cash
|More flexibility due to margin
|Provides leverage for trading
In this article, we tried to inform you about cash and margin accounts. To conclude, in short: cash accounts can only be used with available cash and no borrowing. Whereas in a margin account, it provides leverage, which means you can borrow money from brokers, but the potential risk level is high with trading options.
Cash accounts and margin accounts are two different options available to you that have their own pros and cons. You should finalize your risk tolerance level and current financial situation before choosing any one of the two types of accounts. Apart from these things, having proper knowledge and information about trading is of utmost importance. Make your strategies such that you can survive long-term in the financial market.