How A Margin Account Differs From Cash

Brokerage accounts come in two basic forms, and the difference extends well beyond whether borrowing is permitted. The account type determines how trades settle and what the firm may do with the holdings.

What each account permits

In a cash account, every purchase must be paid for in full with settled funds. Securities are held for the customer and cannot be lent by the firm without separate permission.

In a margin account, the customer may borrow from the firm against the value of eligible securities, with the holdings serving as collateral for the loan.

Many investors open margin accounts without intending to borrow, because the type is often the default and because it removes certain settlement restrictions.

Settlement rules and the free-riding restriction

Cash accounts are subject to rules preventing a customer from buying a security and paying for it with the proceeds of selling it before settlement.

Violating this can result in the account being restricted for a period, during which purchases require settled cash upfront.

Margin accounts avoid the issue because the firm extends credit between trade and settlement, which is why active traders in cash accounts encounter restrictions that surprise them.

What the firm gains in a margin arrangement

The margin agreement typically permits the firm to lend the customer's securities to other market participants, which generates revenue for the firm.

It also allows the firm to sell holdings without prior notice if collateral falls below required levels, a right stated plainly in the agreement.

Securities lent out are replaced by a contractual obligation rather than held directly, which is one reason the arrangement is disclosed at account opening.

Maintenance requirements and forced sales

Regulatory rules set minimum equity levels for margin accounts, and firms commonly impose stricter requirements of their own that can be changed at any time.

When equity falls below the requirement, the firm issues a demand for additional funds, and if it is not met the firm sells positions at its own discretion.

These sales occur when prices are falling, which is the mechanism by which borrowing converts a decline into a realized loss the borrower did not choose to take.

What to check before choosing

The account agreement states the lending permissions, the maintenance requirements, the interest rate schedule and the firm's discretion over liquidation.

Accounts can generally be converted between types, though the process and any restrictions depend on the firm and on the positions held.

Because the terms differ meaningfully between firms and can change, the current agreement rather than a general description is the document that governs.