Sometimes it makes sense for an investor to purchase an asset even if he or she does not have the capital to cover its whole value. In these cases, some investors may choose to borrow the remaining capital from their investment brokers. The margin rate is the interest rate that an investor must pay to a broker when buying an asset "on margin," by using funds borrowed from a broker. Brokers receive interest for these loans to compensate for capital given up front to the investor.
Buying on margin allows an investor to invest with more money than he actually has in his account. First, an investor must place a minimum amount of money in his investment account just to get started. Then, if he wishes to buy a security whose price exceeds this amount, he can do so by taking a loan from the broker. This is known as buying on margin, which gives the investor a loan using the assets purchased as security. In turn, the broker receives interest payments established by the margin rate.
As an example of how a margin rate works, imagine that an investor has $1,000 US Dollars (USD) in an account but wishes to buy a stock that's priced at $2,000 USD. To do this, he must buy the stock on margin. In this case, he has to borrow the extra $1,000 USD from the broker to make the purchase.
Brokers usually base the percentage of the margin rate on the loan amount. Imagine that the broker in this example charges a 6 percent interest rate on margin loans of $1,000 USD. That means that investor ends up owing the broker $1,060: the $1,000 USD loan plus $60 USD for interest. This loan can be paid back by either by depositing more money in the account or by selling securities which are equal to or greater than the value than the loan.
Like the use of any other form of credit, making margin purchases can be unwise. If an investor makes a lot of margin purchases, the interest payments that start to accrue based on the margin rate can quickly become substantial. These payments cut into the investor's profit margin, meaning that the assets he purchases will have to perform exceptionally well to cover how much he owes to the broker. For that reason, an investor should generally try to avoid buying on margin as much as possible to avoid these excess charges.