Investing can seem slightly complicated for every newcomer, even if you know where to start. And one of the most significant dilemmas faced by investors is choosing between two major kinds of brokerage accounts: the margin account vs. the cash account. Let’s dive in and break each one down. 

What is a Margin Account?

A margin account allows you to borrow funds from the brokerage firm by using the marginable securities or cash in your account as collateral. Those bonds, stocks, futures, and other securities that can be traded on margin are generally referred to as marginable securities.

In simpler terms, a margin account works much like a credit card by extending you a line of credit to buy securities. 

How Does a Margin Account Work?

Similar to a bank loan, the brokerage firm charges a monthly interest to your account when you take a margin account loan. Though these loans do not generally have strict repayment deadlines, the interest rates are quite high compared to those offered in a home equity line of credit (HELOC). 

The Federal Reserve Board has imposed certain regulations when it comes to trading through margin accounts. Before you start trading, you are required to make a deposit of at least $2,000, which is known as the minimum margin. The initial margin, the maximum amount you are permitted to borrow, is 50 percent of the price of margin securities. 

It is also ruled that you must always have at least 25 percent of the total market value of the margin securities as a maintenance requirement in your account after trading.

When the maintenance requirement goes below the minimum margin, the brokerage firm issues a margin call asking you to deposit more money into the account or sell any of the securities in the account so as to satisfy the regulations. It is important to remember that the firm has every right to sell the securities without further notice to bring up the minimum balance in the account in case you are unable to meet the requirements of the margin call. 

What is a Cash Account?

A cash account is very similar to a bank account in that all securities purchased through such an account have to be paid for by the amount present in the account. 

The Federal Reserve Board’s Regulation T rules that for you to make a purchase through a cash account, the account must hold sufficient funds or the brokerage firm must accept in good faith that you will make the full payment before selling it. 

How Does a Cash Account Work?

The major setback of a cash account is that since the full amount for each purchase must go from the account itself, you can’t always sell a stock and purchase on the same day, unless you have sufficient balance in your account. It takes up to two business days before the trade settles after a sale and the cash is available to you. This is known as the T+2 settlement cycle.

In addition to preventing buying on margin, a cash account does not allow freeriding or short selling either. If found freeriding, the brokerage firm can freeze your account for the next 90 days. 

Margin Account vs. Cash Account: The Differences

The major difference in a margin vs. cash account comparison is similar to the comparison between using a credit card and a debit card. While you are limited by the funds currently in the account when using a cash account, a margin account gives you a line of credit on interest that increases your purchasing power. 

Cash accounts also impose restrictions on futures trading, which generally requires a margin account. Short selling and selling of uncovered options are not permitted either. 

Further, a cash account gives you the leeway to hold your stock while it drops in value and wait for it to rise, while a margin account would require you to sell it at a loss, so as to prevent larger losses. 

Margin Account vs. Cash Account: Which is Better?

In a margin account vs. cash account comparison, both have their own pros and cons and it is impossible to conclude whether one is generally better than the other. Therefore, your choice of a brokerage account must depend mostly on whether you are ready to take risks or not. 

Margin accounts can greatly increase your returns. But they can also heighten your losses, as you can lose more than what you’ve invested if there is a rapid drop in the value of the stock. 

A cash account, on the other hand, prevents you from experiencing huge losses by limiting the loss to the amount invested. Your gains are limited to your investment, but you don’t have to be concerned about margin calls all the same. 

A cash account might be a more realistic option if you are an everyday investor or a novice in the field. But if you are aware of the risks and are confident of going ahead without suffering major losses, a margin account might be the one for you.

Margin Account vs. Cash Account: FAQs

Can you change a margin account to a cash account? Yes, you can. However, most brokerage firms do not offer this option since margin accounts are more profitable for them. But most firms do offer a cash account to margin account upgrade.

Do cash accounts permit day trading? Day trading is generally prohibited in cash accounts. It is only permitted to the extent that the trades do not violate the prohibition imposed on freeriding. 

Is the T+2 settlement period applicable to margin accounts? No. With a margin account, you do not have to wait for a trade to settle in order to purchase another security. This is what makes day trading easier in margin accounts. 

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Finally, in a margin account vs. cash account comparison, the final choice must always rest on your level of experience and how much risk you are ready to take.