MTF is a service offered by stockbrokers that allows investors to buy securities with just a partial payment while the broker funds the rest. The amount borrowed incurs an MTF interest rate that is paid by the investor till the position is squared off or settled. Many investors use MTFs as a way to enhance their leverage in the market. However, even in instances where the MTF interest rate is low, the MTF can sometimes prove more costly than initially anticipated.
Here are five cases in which this may happen:
1. Longer Period of Holding
Interest on borrowed amounts is charged daily under MTF. The longer the holding of a position, the more the total interest accrues, regardless of a lower MTF interest rate. In other words, borrowing ₹1,00,000 at an interest rate of 12% per annum means paying around ₹10,000 if the position were held for 10 months. Extending the holding period beyond that will add to the overall costs, irrespective of the rate being relatively low.
This situation is pertinent when MTF is used for medium to long-term positions vs. short-term trading. The longer the funds are kept borrowed, the more interest is built up, which in turn may eat up or even cancel the profit from the investments.
2. Price Value Decline of the Stock
The performance of securities under MTF has a say in how one earns or loses. A drop in the cost of any security has a way of eating into a low MTF interest rate secured profit. For instance, shares of ₹1,00,000 fall by 10%, which in turn reduces the portfolio value by ₹90,000; thus, the investor pays interest on the borrowed amount as well, and this adds to the loss.
In this instance, mtf interest rates are not compensating for price negative movement risk. Losses from falling stock prices plus interest add to the burden.
3. Extra Charges Above and This Interest
Other than the mtf interest rate, various costs can be incurred while margin trading. These may include brokerage charges, pledge fees, account opening, and maintenance fees etc. For example, there could be charges involved every time securities are pledged or unpledged to avail of MTF.
Although they seem small by themselves, these extra charges over time become significant in raising the effective costs of using MTF. So, this means that even interest charged is low, the total cost is still high.
4. Margin Calls and Forced Liquidation
In an MTF arrangement, investors must keep a minimum margin as collateral. When the stock price goes down, thus the margin requirement is less than the minimum required margin, the broker could then square off the position to recover its funds. This is forced liquidation.
In this scenario, the investor ends up incurring two costs:
Realized trading loss due to stock price drops. Interest is charged till liquidation
That said, rightly so, if any forced liquidation occurs after borrowing at lower MTF interest rates, it will hurt the investor way more, negating any hoped-for benefits. Investors are now stuck with paying interest while never enjoying any promised gains.
5. Opportunity Cost Lost for Capital
This refers to the capital that has been rendered useless while paying interest under MTF. Even otherwise, even lower MTF interest means periodic payments modulate investor liquidity owing to different opportunities.
For example, if an investor puts down ₹1,00,000 under MTF and then pays ₹8,000 yearly interest on that, he could have used this money for some other investment or to fulfill a financial need. Gradually, this restricts flexibility and can make the overall MTF cost very much higher than anticipated.
Conclusion
MTF extends an extra fish in the barrel to investors and encourages them to augment their stock market exposure. However, just because the MTF interest rate is lower does not mean overall costs have to be lower. Longer holding times, stock depreciation, other broker costs, forced liquidation, and opportunity costs are all reasons to look at MTF and really drive up the effective cost of using it. Assessing these scenarios will help measure the real hit margin that investing will withstand.
