What is Leverage?

My mom really enjoys the televisions show "Leverage." Hedge fund managers on the other hand tend to enjoy the financial type of leverage. You've probably heard of terms like "Leveraged Buyouts" on TV, but most of us haven't really though about what leverage means in that context. So, when talking about finance, what is leverage and is it good?

Leveraging Things

In physics we use levers to amplify force. If for example I'm trying to get my front door open, a crowbar used as a lever can help me pry it ajar when I couldn't have done so otherwise. The tool helps me amplify the force I can use on the door.

In finance, leverage is the same thing. At its root it's the act of using something to amplify the force of my investments. Typically the thing I'm using to leverage my results is debt.

An Example

Suppose for example that I can borrow money at 4% and have a surefire investment that will return 10%. If I have $100 in the bank, I could just invest that money and make $10 in the next year using my 10% opportunity. If on the other hand I borrow another $900, I could invest the $1,000, make $100 and only have to pay $36 in interest, leaving me with $64. So by borrowing that $900 I've made $64 instead of $10. Sounds awesome right?

Another Example

Unfortunately leverage can also work against us. Suppose that instead of making 10% in my example I lost 10%. Now instead of just losing $10, I lose $100 (10% of the $1,000). To make matters worse I also have to pay $36 in interest on the money I borrowed, so instead of just losing $10, I lose $136. Not so awesome.

Real-World Examples

Probably the most common example in your life of leverage is when you buy a house. Typically most of us don't have enough money to buy our house in cash. Moreover, historically real estate has appreciated pretty quickly. So if real estate is appreciating at 8% per year and I can borrow money at 5% per year, I'm using leverage to make my wealth grow faster.

As you can see, by using leverage I'm amplifying the effect of whatever I'm doing. If I make money, I make more. If I lose money, I lose more. This is why you need to think carefully before you apply leverage to your investments. Many of the causes of the banking crisis in 2008 were related to banks that had leveraged themselves to far when markets turned against them. So while leverage can be your ally, it needs to be applied carefully.

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