Buying stocks on borrowed money can get dangerous

Staying Ahead

June 18, 2000|By JANE BRYANT QUINN

Rising interest rates are about to pinch.

First, they'll take a nip out of your everyday spending power. Rates will rise on your credit-card debt, home-equity loans and adjustable mortgages.

On the second front, rising rates continue to undermine stocks and stock-owning mutual funds. You're especially vulnerable if you borrowed money to invest.

In 1998 and 1999, it seemed to make sense to go into debt to buy stocks. The market rose enough to give you a profit after expenses. A record number of investors borrowed from their brokers (those are called "margin loans"). Others went into the market with money from home-equity loans.

This year, many of those with margin loans are getting killed. The jury is out on whether the home-equity loans will pay.

When home-equity loans were at 8 percent and the stock market rose by more than 20 percent, you were doing fine. Today, the game may have changed. HSH Associates in Butler, N.J., expects home-equity loans to rise to 10.2 percent. That's roughly the long-term average return from stocks.

No one knows how well stocks will do in the future. But at current interest rates, there's a greater risk that your loan strategy will not work out.

One argument in favor of borrowing is that it lets you diversify. Instead of owning just your home, you have a stake in the stock market, too. But if you have a company 401(k) or 403(b) plan, you already have a stock market stake.

The decision to borrow extra money against your home will then depend on how easily you can handle the monthly payments.

You're in a different position, if you took a margin loan. Loans from brokers aren't like bank loans. You can't repay them gradually, over many years.

"First-time or unsophisticated investors don't understand this," says attorney Mark Maddox of Maddox Koeller Hargett & Caruso in Indianapolis. "They think it's like having a mortgage or credit-card debt. They don't understand its severity, if their stocks go down."

If the value of your stocks declines, your broker may issue a "margin call." That means your broker wants you to repay part or all of the loan immediately. If you don't, the broker will sell your stocks, use the proceeds to cover the loan, and give you anything left over. In wicked markets, this happens fast. Your broker can give you a margin call, then sell your stocks while you're scrambling to come up with the money.

Yes, your margin agreement almost certainly lets your broker sell you out.

If the stock dropped so fast that the sale cannot cover your margin loan, you'll have to pay with other funds. The transaction can cost you more money than you originally put up. Many new investors don't realize that.

The dot-com bubble burst in a splatter of margin calls. In April, the margin loans outstanding dropped by almost 10 percent.

Rates on margin loans rise and fall with the market. Small investors pay more than large investors.

Maddox thinks that investors who trade online know the least about their margin debt.

At a full-service firm, a broker might explain it to you. Online, you have to find and understand the rules yourself - and often, the Web sites are pretty vague.

At DLJ Direct, for example, I looked at a Web page called "Tell Me About Margin Borrowing." It touted the benefits at length but had only a brief and mealy mouthed statement about risk, without any specifics.

Ameritrade's site on margin accounts says the firm can sell your stocks if you don't meet a margin call. But you have to go to the handbook they mail, to find out that it can sell even without notifying you.

E*Trade's "Getting Started" Web page on margin loans doesn't mention risk at all.

DLJ does link you to a Securities and Exchange Commission site (www.sec.gov/consumer/margin.htm) that's very specific about risks. But you have to ask: How come the firm didn't tell you itself?

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