Leverage

Leverage refers to the use of borrowed funds or debt to increase the potential return of an investment. It is the process of using debt to finance an investment, which can magnify both the returns and the risks of an investment.

Example

Suppose you want to buy a house worth $100,000. You have $20,000 in savings and you can borrow $80,000 from a bank at a 5% interest rate.

Without leverage, you would only be able to buy the house using your $20,000 savings. If the house increases in value by 10%, your return on investment would be $10,000 or 50%.

With leverage, you can use the $80,000 borrowed from the bank to buy the house. If the house increases in value by 10%, your return on investment would be $10,000 minus the interest paid to the bank, which is $4,000. Your return on investment would be $6,000 or 30%.

While leveraging magnified your returns, it also increased your risks. If the value of the house decreases by 10%, you would lose $10,000 without leverage, but you would lose $14,000 with leverage.

Advantages of Leverage

- Magnifies potential returns: Leverage allows investors to amplify the potential returns of their investments.
- Increases buying power: Leverage allows investors to buy assets that they would not otherwise be able to afford.
- Increases diversification: Leverage enables investors to diversify their portfolios by investing in a larger number of assets.

Disadvantages of Leverage

- Increases risk: Leveraging an investment also magnifies the potential losses. If the value of the investment decreases, the investor may lose more than the initial investment.
- Increases costs: Borrowing money comes at a cost, which is the interest rate paid on the loan. The higher the interest rate, the higher the cost of leverage.
- Requires collateral: Lenders often require collateral to secure the loan, which means that the investor must pledge assets to guarantee repayment of the loan.

Conclusion

Leverage can be a useful tool for investors to increase their potential returns, but it also comes with increased risks and costs. It is important for investors to understand the risks and benefits of leverage before using it to finance their investments.