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In Stocks, the Margin Isn't One of Safety

It was vampish Mae West who famously said, "Too much of a good thing can be wonderful." She didn't have investments in mind, but the comment works for the stock market, too. Gains such as those of 1995 and the first weeks of 1996 are bringing out, in many investors, a mad passion for excess.

Not content with pouring record amounts of money into mutual funds, they are borrowing to invest even more. The discount brokerage firm Charles Schwab Corp. estimates that about 10 percent of its margin loans have been used to buy mutual funds. You gamble at your peril, however, given the market's nosebleed heights.

You're "margined" when you borrow money against your securities. Most people margin stocks and bonds in order to buy more of the same. But you also can borrow as much as 50 percent of the value of diversified mutual funds -- something many investors don't know.

To buy funds on margin, you have to open an account with a stockbroker. You probably have an account already, if you work with a full-service stockbroker (full-service firms charge sales commissions and dispense investment advice). But if you invest in no-load funds (funds with no sales commissions), you've probably been buying directly from the fund company itself. Mutual funds don't give margin loans.

No-loaders would have to switch their shares to a margin account with a discount broker, such as Charles Schwab or Fidelity Investments. The broker handles the paperwork, which takes three to four weeks. You need a discount broker because full-service brokers might not accept no-load business.

In some cases, you'll have to buy shares for cash, then wait 30 days before taking the loan. In other cases, you can borrow right from the start. It takes $10,000 cash to acquire $20,000 worth of shares, in the same fund or in different funds.

But you can borrow only against the diversified funds, including the internationals. Loans generally aren't granted against narrow-interest funds, such as those invested in just one industry. And you can't margin funds in tax-deferred retirement accounts.

But is this tactic worth the risk?

If the markets soar even more, margin buyers will get larger net returns. That's assuming you sell your shares and repay the loan. Buying on margin makes no sense for investors who will hold for the long term. If the market is flat to down, however, margin buyers will net smaller gains or larger losses than if they hadn't borrowed at all. That's because you have more shares in play.

The interest rate can change daily on your margin loan, and can vary under a multi-tiered system based on the loan's size. Schwab's current rate for small loans is 8.75 percent annually (rates are lower on larger loans). Merrill Lynch charges 10.375 percent on small loans. Your fund's total return has to exceed your loan interest rate before you start making any money. If it doesn't, the loan will be a drag on your account.

After tax, your break-even point may be significantly higher than, say, 8.75 percent. You're allowed to deduct your margin loan interest from your taxable investment income, such as dividends. But you may not have many dividends in a given year.

To take one example, a typical Maryland investor with no loan interest deduction might need to earn more than 12 percent to make the loan worthwhile, says fee-only financial planner Steven Ames of Annapolis.

By that arithmetic, it makes no sense to buy a traditional bond fund on margin, said planner Lynn Hopewell of the Monitor Group in Fairfax. It's rare for bond-fund returns to exceed 8.75 percent. Stock funds have a better shot.

If the stock market declines, you run the risk of having your fund sold out from under you. That's because the account's total value, minus the loan, isn't allowed to fall below 25 percent of the market price. Schwab, Merrill Lynch and many other brokers put the limit at 30 percent. If you drop below the line, you'll get a "margin call," asking you to put more cash or actively traded securities in your account. If you can't, enough shares will be sold to bring your account value up to the proper level. One way to reduce the risk of calls: borrow less than the 50 percent limit.

But why run the risk at all? Margin loans get popular when the stock market is up -- exactly the time when there's less room for gain and more likelihood of loss.