Of the many financial concepts, leverage is less understood than most but can be as helpful to an investor as coumpound interest. It is somewhat understandable, as most people's involvement with leverage is mostly limited to their home. We are not given a lot of reasons to spend time thinking about leverage and how it helps us or hurts us.

Definition

leverage - n. The multiplier for the percentage gains (or losses) of an invested dollar due to the use of debt, options, or other financial instruments over the straight purchase of the underlying asset.

Easy to understand right? No? Lets look at a common example then.

House and Home

Assuming you own a home, it was probably the largest purchase that you have ever made. Most likely, it cost enough that you could not pay for it all up front. Thus, you got a mortgage to cover the rest of the cost. That mortgage gave you leverage.  Here's how.

  1. Using a $200,000 house as an example.  A $40,000 down payment allows you to control the house for only 20% of the purchase price.  With other loan programs, you can do the same thing for as low as 3% of the purchase price, which provides even more leverage.
  2. If the value of the home goes up 5% in the first year, to $210,000 your equity has increased from $40,000 to $50,000 for a 25% gain.  Yes, this gain is offset almost completely by the interest paid on the mortgage.  However, the tax benefits help reduce this cost and the cost of renting an apartment or other place to stay is going to be similar to the mortgage interest expense*.
  3. For investing, this works out even better.  20% down on two properties multiplies the returns through increased leverage over 40% down on one property.  Assuming that the cash flow on the properties meets the costs of the property, 20% down results in twice the gain in appreciation.  Not to mention increased cash flows for the future.

Taxes, interest, maintenance, services and depreciation do add to the analysis and viability of a real estate deal.  They do not impact the basic impact of leverage on the overall level of returns.

*Home ownership is not for everybody.  The potential appreciation is not worth the added monthly costs and work over living in an apartment.  Other reasons to avoid purchasing can include frequent moves (the buying and selling costs are significant), highly variable income, families in flux and exorbitant local home prices .

Other Sources of Leverage

Homes are not the only source of financial leverage in our lives.  They just happen to be the main one that is an asset.  Since a home is an asset, it can also be a positive form of leverage where you come out ahead at some point in the future.  Done wrong, like many homeowners in the sub-prime meltdown are finding out, the leverage can backfire and wipe you out financially.

Other forms of leverage have much less upside.  Leasing or getting a loan for a nice car is an example.  You pay a little now - much less than the car is worth - to control a nice and expensive vehicle.  At the end, a lot of money has been paid out for either nothing (with a lease) to keep or for a vehicle which is worth much less than when you acquired it.

Using credit cards for vacations and other wants is an even worse example.  For little or no money up front, the trip of a lifetime can happen. Then, when all of the benefits of the trip are gone, the payments for the trip continue.

Summary

Leverage is using a little bit of money to gain control over something that is worth more than the initial investment.  This can happen because somebody else takes responsibility for the rest of the money needed and the first person agrees to a cost for them doing so.  Done right, the first investor multiplies his returns from the leveraged investment.  Done wrong, the first investor may wind up owing more money than he initially risked.

Leverage is a large topic.  In the financial markets, fortunes are made and lost rapidly using leverage.  What we have discussed here barely scratches the surface of what individual investors can do with leverage.  Like all tools however, it has its own risks and rewards.  Due to the nature of leverage, it is something t be taken on very carefully, lest it wipe out an investor's entire net worth or more.

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