Cash accounts and margin accounts are the two main types of brokerage accounts. While there are many differences between the two, the most notable is that a margin account allows you to borrow money and trade on margin while a cash account does not.
What Is a Cash Account?
A cash account is one of the two main types of brokerage accounts. With a cash account, the account holder must have enough cash to cover all transactions in full.
A cash account does not mean that the brokerage account is fully invested in cash. It merely means you must have enough funds in the account to cover a transaction. It’s similar to purchasing at a store with cash. To make the purchase, you must have the full amount of money.
Cash accounts are about as straightforward as it gets, but we’ll still look at a quick example of how cash accounts work.
Let’s say you have a cash account, and you want to buy ten shares of Apple (AAPL). If Apple is trading at $126 per share, then ten shares will cost $1,260. If you only have $1,000 available, buying ten shares isn’t possible. You would need to deposit more cash in order to buy all ten shares.
This may all seem obvious. If you don’t have the cash to cover a transaction, how can you possibly make it? This leads us to the second type of brokerage account: margin.
The other primary type of brokerage account is a margin account, which allows traders to borrow money to enter new positions.
Margin accounts enable you to use leverage, an investing strategy using borrowed money to increase the potential return on investment.
While not the same, it’s somewhat similar to purchasing with a credit card. You don’t have the cash on hand, but someone (in this case, the credit card company) is willing to let you borrow the money. In the case of this type of brokerage account, the person allowing you to borrow the money is the broker.
Why would a broker allow you to borrow money? For the same reason, a credit card company will enable you to borrow money – the borrower earns a profit. In this case, the borrower (the broker) can profit from the investment, interest paid on the borrowed money, and any fees.
Since a margin account makes trades using borrowed money, margin accounts are riskier for both the broker and the trader.
First, let’s consider the risk for the broker. Lending money always comes with risk since it’s still possible that the borrower will not have the ability to repay the loan. Therefore, brokers typically request more information from those opening a margin account than those opening a cash account.
If you choose to open a margin account, brokers will likely ask for your income, net worth, and how much you have in liquid assets. Additionally, they may check your credit score. If the broker reviews this information and decides you’re too high risk, they may not allow you to use margin.
Margin accounts are also riskier for traders since they’re trading borrowed money. Later in this post, we’ll look at some of the specific risks this creates.
If traders must take on more risk and pay interest on any margin loan, what’s the appeal of using margin?
While there are a few additional benefits of using margin, such as the ability to engage in short selling and riskier types of options trading, the biggest reason to trade using borrowed money is that the potential for returns is higher.
For example, let’s consider our Apple example from above – you want to purchase ten shares of Apple, but at $126 per share, your available $1,000 does not give you enough to buy that many shares (1,260). But let’s say you could borrow the money. You use half of your own money (630) and borrow the remaining amount ($630).
Now, let’s say Apple shares increase by 5%. A person who bought the shares in cash would see a 5% return, BUT the person who invested using margin saw a 10% increase since they invested only half as much but saw the same dollar value increase.
While this hypothetical example clarifies the concept of trading on margin, it’s not entirely accurate because it fails to take into account interest and minimum capital requirements that almost always exceed $1,000.
Most margin accounts have minimum capital requirements, which means you must make sure to have a certain amount of capital to open a margin account.
The minimum capital requirement varies depending on the broker, but it’s typically at least $2,000. Additionally, brokers usually require that you have capital equal to 50% (or more) of the trade you’re looking to make. This means that if you want to invest $20,000, you’ll need to have at least $10,000 available.
In contrast, while some cash accounts have account minimums of $1,000 or more, many brokers allow investors to open an account with considerably less capital.
The exact amount of interest a broker will charge on a margin loan depends on the broker. While rates vary, they are often relatively high.
Both the good and the bad news is that unlike most other forms of debt, margin loans don’t have repayment schedules. This provides the benefit of flexibility, but it may also lead to high fees. That’s because the longer you take to repay the loan, the longer the interest has to accrue and the more you end up paying.
While interest and fees are always essential to keep in mind, since they cut into your profit, it’s vital to understand the implications of interest rates on margin loans. The return on your investment will need to exceed the interest rate to come out ahead.
For example, if you have a margin account and your broker charges an 8% annual interest rate, the return on your investment will need to exceed 8% for any borrowed money.
Margin calls occur when the broker requires the account holder to increase the value of the account.
When and why would a broker do this? Let’s look at an example to see.
Let’s say you have a margin account. You make a $20,000 investment, half of which is all of your available cash and half of which is a margin loan. Your portfolio’s value is currently $20,000, $10,000 of which is your money, and $10,000 is the broker’s money.
Now, let’s say there’s a dramatic dip in the market, and the value of your portfolio drops by 40%. The value of your portfolio is now $12,000. Regardless of the drop in value, you still owe the broker $10,000 (not including any interest you may owe). At this point, only $2,000 of your portfolio is your money.
Brokerages typically have a “maintenance margin”, which is how much of the portfolio must consist of your cash or securities. If the maintenance margin were 25%, you would need to have $3,000 of your money invested in your $12,000 portfolio. Since you’re below that amount, the broker would have a margin call, which means you would need to come up with an additional $1,000, either by depositing more cash or selling securities; otherwise, the broker may raise available cash for you without notice.
Margin calls are one of the most significant risks of margin accounts.
Trade settlement is when a transaction officially completes, meaning the buyer receives the securities and the seller gets the cash. With a cash account, you must remain aware of settlement requirements to avoid violating them, but this is less of an issue with margin accounts.
For a cash account, the trade settlement is typically two days after the trade occurs (commonly written as T + 2). This means if you place a trade on Tuesday, the transaction won’t settle until Thursday.
If you’re not aware of trade settlements, you may incur a settlement violation. There are a few ways this may happen, but let’s look at one of the most straightforward examples.
Let’s say you place a trade on Tuesday to sell $1,000 worth of Company A. You will not receive the cash from this sale until Thursday. Until that point, the funds from the sale are unsettled. That same day, you use these unsettled funds to purchase $1,000 worth of Company B. The following day, Wednesday, the price of Company B increases by 20%. You sell your shares of Company B for $1,200 before the funds from your sale of Company A shares have settled. This is a settlement violation.
Settlement violations are less of an issue with margin accounts but can still occur, especially when trading securities that are non-marginable.
Due to the riskier nature of margin accounts, there are additional regulations on these accounts, the violation of which may lead to sanctions.
One trading rule that may lead to sanctions is Regulation T, which states that if the margin account owner has a shortfall of $1,000 or more, the account must either be liquidated or apply for an exemption.
Another is SEC Rule 15c3-3. This rule requires the broker to purchase replacement securities if a security fails to be delivered within ten days of settlement. This means that even if you cannot complete a trade (you lack either the securities or the cash), it is the broker’s responsibility to ensure the trade settlement. While this may sound nice on paper, since it seemingly reduces your burden to settle a trade, it results in brokers penalizing you or potentially even closing your account.
The most significant advantage of a margin account is arguably the ability to trade on margin (AKA borrow money from a broker). Still, there are other advantages to a margin account that may make it worth the additional risks. The biggest of these is the additional flexibility provided by a margin account.
Here’s how that additional flexibility impacts different types of transactions.
Short selling is essentially a way to bet against a company. When you short a stock, you are assuming the stock price will decrease, and you plan to profit from this decrease. You borrow the owner’s shares and expect to buy them back at a cheaper price, usually in the short term, pocketing the difference. While shorting comes with its risks, it gives traders the ability to profit in a bearish market. Short selling is only allowed in margin accounts.
Day trading is entering and exiting a position in a short period, typically one day or less. The profits made on these short-term trades are relatively small, but the goal is to make small gains consistently enough to add up to sizable returns. Day trading with a cash account is possible but may lead to accidentally violating specific regulations.
Options trading is the process of buying and selling options. Options are contracts that give the investor the option, but not the obligation, to buy or sell an underlying security before a specific expiration date. Options trading is divided into five levels, depending on the level of risk involved. Levels three to five require a margin account.
Whether a cash account or a margin account is right for you will depend on what you’re looking for in a brokerage account and your experience and knowledge regarding trading.
The first thing to consider is whether you have the capital necessary to meet the minimum capital requirement. If not, at least for the time being, a cash account is likely the better option.
The other thing to consider is the level of risk you’re comfortable assuming. All trading involves some amount of risk, but as we’ve seen, margin accounts come with more risk than cash accounts for several reasons.
There’s also the question of what kind of trading strategy you’re following. If you’re interested in short-selling, day trading, or options strategies, a margin account will likely be your better option.
We’ve covered a lot about both cash accounts and margin accounts. Let’s now break down the pros and cons of each into a few key bullet points. We’ll begin with the pros and cons of cash accounts.
- Typically have lower minimum capital requirements
- Lower risk than margin accounts
- Fewer rules and regulations than margin accounts
- Less likely to incur sanctions from violating regulations
- Do not have the ability to trade on margin
- Cannot engage in short selling
- Cannot engage in riskier types of options trading
- Easier to accidentally violate day trading regulations
Now, let’s consider the pros and cons of margin accounts.
- Ability to trade on margin
- Higher potential return on investments
- Can engage in short selling
- Can engage in riskier types of options trading
- Easier to day trade
- Higher risk than a cash account
- Risk of a broker making a margin call that you cannot meet
- You pay interest on the margin loan, which eats into any potential profits
- Higher minimum capital requirements than most cash accounts
- More rules and regulations
- Chance of incurring sanctions due to violations of regulations
If you prefer visualizing the pros and cons altogether, here is a table to help you do so.
|Type of Account||Pros||Cons|
|Cash Account||Lower minimum capital requirements||Cannot trade on margin|
|Lower risk||No short selling|
|Fewer rules and regulations||No riskier types of options trading|
|Less likely to incur sanctions||Day traders may violate regulations|
|Margin Account||Can trade on margin||Higher risk|
|Higher potential returns||Risk of margin call|
|Short selling allowed||Higher minimum capital requirements|
|Riskier types of options trading allowed||Higher minimum capital requirements|
|Easier to day trade||More rules and regulations|
Can I Change a Margin Account to a Cash Account?
Most brokers allow you to change your type of account fairly easily. All you usually need to do is call your broker.
If you have a cash account and want to change it to a margin account, you’ll have to meet the requirements. On the other hand, if you’re interested in changing your account from a margin account to a cash account, typically, all you need to do is ask. The exact process will vary from broker to broker, but a customer service representative at any major US brokerage firm should be able to walk you through the process.
You may want to change your margin account to a cash account if you opened a margin account but found the complexity of the rules and regulations overwhelming. Additionally, you may wish to switch from a margin account to a cash account if your risk profile has changed. While you may have previously been able to handle the higher risk of a margin account, you may no longer have the ability or the desire to maintain that level of risk.
If you choose to open a margin account, it’s essential to use it wisely.
Margin accounts come with higher risks. Using a margin account wisely requires making sure you understand the amount of risk that you can safely handle, as well as the amount of risk you’re comfortable assuming. Then, make sure that your investments do not exceed this risk level.
You’ll also want to educate yourself on the various rules and regulations that come with a margin account. The better you understand these, the better chance you have of avoiding a violation that may lead to sanctions or even the closing of your account.