What Is Leverage?

Leverage is when you borrow money to buy an asset you expect to appreciate in value and bring returns. The more money you borrow or the more debt you accrue to pay for the asset, the greater the leverage.

Leverage can work in your favor when you buy an asset that appreciates and ends up paying for itself. Another way to look at it is that leverage can help you compound your returns. The downside of leverage is when you borrow money to purchase an asset and it declines in value. Not only do you not generate any income from the asset, but you also still have to repay the debt you borrowed.

Before using leverage in your personal life, business, or when investing, it’s critical you weigh the risks. If things don’t go as planned, you could end up in debt.

How Leverage Works

There are several types of leverage including leverage in business and personal finance. While there are nuances between each type, the fundamentals remain the same.

Business
When companies use leverage in business, they may take out small business loans or credit cards to pay for transactions or scale their business. It can be a better alternative than distributing more shares in the company, which can reduce shareholder value.

Leverage can especially be helpful to small businesses who don’t yet have much assets or capital. A bonus is that interest payments on any line of credit taken out by a business are tax-deductible.

Another alternative for businesses to borrow funds other than taking out loans is to issue corporate bonds. With corporate bonds, companies borrow money from investors and are obligated to pay back the principal on a specific date in addition to interest.

Personal Finance
Personal finance is another area where leverage can be used. For instance, when people take out student loans, that’s a form of leverage. A student usually takes on debt to invest in their education with hopes that they’ll secure a well-paid job in the future. If it works out that way, they can pay off the loan and eventually end up in a better financial position than if they didn’t take out that debt for education. That said, for students who took out loans to attend schools that defrauded students like Corinthian College, leverage didn’t work in their favor.

Another example would be taking out a mortgage loan to buy a property. As you pay off the loan, you build equity and the property may also appreciate in value. Likewise, you could take out a home equity line of credit (HELOC) and invest it in another asset.

Leverage In Investing

When you leverage in investing it’s known as buying on margin. To buy on margin, you open a margin account, which enables you to borrow money to make larger investments. For the most part, your broker will usually let you borrow up to 50% of the purchase price of your margin investment.

For example, if you wanted to buy an asset that costs $100,000, you could use $50,000 of your money and the broker could lend you another $50,000 and charge you 3% annual interest. Let’s say the value of the asset rose 40% to $140,000. You would pay the broker back their $50,000 plus $1,500 interest and pocket a $38,500 profit. By buying on margin, you almost doubled your profit. If you only invested $50,000 and it rose by 40%, you would have only made a $20,000 profit.

It’s important to note that these loans aren’t collateral free-the securities you buy and any cash you have in your margin account can be used as collateral. There are also minimum equity requirements on margin accounts. If the value of your shares declines below that threshold, a margin call takes place. This is when your broker asks you to deposit more money into your margin account to meet the minimum equity requirements. Alternatively, the broker may sell some of the shares in your margin to meet that minimums requirement.

Margins are risky business because if your investment goes left, you still have to pay your margin debt coupled with interest. If it goes well, you make profit on the investment and can use that to pay your debt.

Leveraged ETFs

Leveraged exchange traded funds (ETFs) are another way to use leverage in investing. In this case, you would borrow money to try and realize gains on benchmark indexes. It’s a lower risk approach because you don’t have margin calls and can’t lose more than your initial investment. Keep in mind that leveraged ETFs are usually short-term investments, meaning investors only hold them for a few days and that also means they have higher expense ratios than index funds that are held for longer periods.

Leverage can lead to greater returns but it can also lead to significant losses, which is why you should know your risk appetite before using this strategy. If you need advice on leverage, reach out to a finance professional on our team.