Leverage is debt. Debt must be repaid. It is also an investment strategy of using borrowed money to generate outsized investment returns. Before getting into greater detail on how leverage works in an investment context, it is useful to have a broad understanding of the general topic. Let’s start with a familiar example.
You buy $100k house, you put down $20,000 (20% down payment), spend $5,000 to give it a good paint job, change a couple of windows and door. Total investment of $25,000. Turn around and sell the house for $150,000. That’s 100% gain, because you’ve leverage the $80,000.
It takes wealth to create wealth.
If you can can do $50K gain per house for 40 times. That’s your 1 million of gross profit right there. And if you double the leverage each time, and make 100% profit each times, you only have to do this 7 times to get to $1.2 million mark. Well, whether the bank let you do it or not it’s up to them, but that just shows how powerful leveraging can be.
- The use of leverage in real estate investing is similar to the way it can be used in the stock market. Margin loans, futures contracts and options are a few of the more common methods investors use to add leverage to their portfolios. Just as in the real estate example, a limited amount of money can be employed to control a larger amount of stock than would be possible through a direct purchase made with available cash.
- I don’t endorse margin investing because if you face margin calls, you could stand to lose a lot of money. But just for this purposes, I just want to show.
- Bond-market investors can also use leverage. Consider a scenario in which the interest rate on a one-year loan is 1% while the interest rate on a 10-year loan is 5%. By borrowing money at the short-term rate and investing it at the long-term rate, an investor can profit from the difference in rates.
You live in it – your house is a form of leverage. Most people steer away from debt free and clear. Although they may not think about it as leverage, most people use a mortgage when they buy a home. They pay off the loan over a period of years or decades, all the while getting to enjoy the use of the property. The moral of the story is that leverage is a common tool that works well, when used prudently.
Education – Student loan is a form of leverage. You trade your time in school instead of working. You borrow the money to obtain a degree and hoping that degree can lead to more money. That’s leveraging.
Time – Says you are in the medical field working at $50, and you don’t know anything about plumbing, instead of spending 10 hours to fix a plumbing issue, you can hire a trademan for 1 hour at $25. More efficient, you delegate the time for cheaper, saving you $25.
Downside of Leverage
Leverage is a multi-faceted and complex tool. The theory sounds great, and in reality the use of leverage can be quite profitable, but the reverse is also true.
If you use a $100,000 down payment to purchase a $500,000 home, and real estate prices in your area decline for several years in a row, the leverage works in reverse. After year one, your $500,000 property could be worth $475,000 if it depreciates by 5%. A year after that, it could be worth $451,250 – a loss in equity of $48,750. This happened in 2008-2011 when the housing market crashed in the US.
The Bottom Line
When it comes to leverage, unless you are a professional trader and your losses will be covered by your employer, leveraged investing should probably not be your primary investment strategy. If you are not a professional and you choose to use leverage, don’t invest more than you can afford to lose. Also, be sure to conduct careful research and make prudent decisions. This approach is more likely to result in a positive outcome than blindly investing in a hot trend based on your observation that other people are making money in real estate, currencies, stocks or some other investment vehicle that has become so popular that investors are borrowing money to buy it.
So use it wisely to increase your asset level and net worth.