Long-term (since 1925), stocks have gained around 11 percent per year. Over the past 10 years, the annual return has been almost 13 percent, according to Ibbotson Associates, Chicago; for the past 25 years, the number is nearly 14 percent. Thus, it may make sense to pay margin interest at 5 percent per year (or even 8 to 9 percent) in order to buy stocks that will earn 11 to 14 percent per year.
The tax code may make this strategy even more appealing. In many situations, the interest you pay on a margin loan is deductible from your taxable income. If you borrow to buy securities and if you report substantial amounts of taxable investment income, you probably can deduct your margin interest. Thus, on a 5 percent margin loan, you’d effectively only pay around 3 percent.
Moreover, any stock market gains can remain untaxed for years. Those gains will be taxed only when you cash them in and may be taxed at favorable long-term capital gains rates. Thus, if all goes well, you can borrow at 3 percent or 4 percent or 5 percent, aftertax, and eventually realize gains of 8 percent to 11 percent, after tax.
The catch? All might not go well, and the stocks you buy might go down. If so, you may receive a “margin call,” asking you to add more cash or more securities to your account. If you don’t comply swiftly, the brokerage firm will sell securities from your portfolio to protect its collateral.
