Some investors attempt to enhance their portfolio returns by using financial leverage, such as options or margin borrowing. Margin borrowing is probably the more popular leverage-enhancing technique used by individual investors. By borrowing "on the margin," i.e., from one's brokerage firm to purchase shares of stock, the investor can achieve large returns in a short amount of time if shares of the stock held rise rapidly. Downside risk is also enhanced for the same reason.
Despite its relatively common use, margin borrowing is unsuitable for many small investors, primarily because the margin interest rates charged by brokerage firms tends to be very high. For example, the FED recently cut its overnight lending rate to banks to 4.50%. However, most brokerages are still charging margin interest rates exceeding 10%.
Fidelity, for example, currently charges a margin interest rate of 10.325% to anyone borrowing less than $10,000. Fidelity, however, provides a great incentive to wealthy investors who want to borrow on the margin. As of October 31, 2007, Fidelity only charges a margin interest rate of 5.25% to anyone borrowing $500k or more, as shown in the chart below:
If I had a large brokerage account, I would certainly consider borrowing from Fidelity to purchase shares of certain equities. For risk tolerant investors, 5.25% seems like a small price to pay for the potential returns possible from margin borrowing. If I were to borrow on the margin, I would probably use the borrowed money to purchase shares of an index-tracking ETF, such as the S&P MidCap 400 Index ETF (symbol: MDY) or the S&P 500 Index ETF (symbol: SPY), to minimize individual company-specific risk.
There may be additional tax benefits that further enhance the desirability of margin borrowing. Qualified dividends are currently taxed at a maximum rate of 15% per year. If one has enough deductions to itemize on one's federal tax returns, one can deduct margin interest against one's federal income taxes, giving the person an additional benefit. If the person is in the highest marginal tax bracket, that person will effectively be deducting the margin interest against income that would be taxed at a rate of 35% per year.