Leverage is a concept that can be tricky to understand, especially if you’re not familiar with financial jargon.
But don’t worry – we’re here to help!
In this post, we’ll explain what leverage is, how it works with money, and give you some simple analogies and examples that should make it easier to understand.
So, what is leverage?
At its most basic, leverage is the use of borrowed money to increase your potential returns.
It’s like using a lever to lift a heavy object – the lever magnifies your strength, allowing you to lift more than you could on your own.
Similarly, leverage magnifies your investment returns, allowing you to earn more money than you could with just your own capital.
Let’s say you want to buy a house, but you don’t have enough money to pay for it outright.
You could take out a mortgage, which is a form of leverage. The mortgage lender gives you the money to buy the house, and you agree to pay them back with interest over time.
By using leverage, you’re able to buy the house now instead of waiting until you’ve saved up enough money on your own.
But how does leverage increase your potential returns?
Well, let’s say you buy a house for $200,000, and you put down a $40,000 down payment.
You finance the remaining $160,000 with a mortgage at a 4% interest rate.
After a few years, the value of the house has gone up to $250,000. If you had bought the house outright with your $40,000, your return on investment would be 25% ($50,000 profit on a $200,000 investment).
But because you used leverage, your return on investment is actually 125% ($90,000 profit on a $40,000 investment).
That’s because you’re earning a return on the full $200,000 value of the house, not just the $40,000 you put down.
Of course, leverage can work against you too.
If the value of the house had gone down to $150,000 instead of up, your return on investment would be -25% if you had bought the house outright, but it would be -175% if you had used leverage ($-70,000 loss on a $40,000 investment).
That’s why it’s important to be careful when using leverage, and make sure you can afford to repay any loans you take out.
Another analogy that might help you understand leverage is a see-saw.
Imagine you’re playing on a see-saw with a friend who weighs twice as much as you.
If you’re both sitting in the middle, the see-saw is balanced. But if your friend moves closer to the center, they’ll be exerting more leverage on their side, and the see-saw will tilt in their direction.
Similarly, when you use leverage to invest, you’re putting more weight on one side of the see-saw (the side with the borrowed money), which can cause your potential returns to increase or decrease depending on how the investment performs.
With all of the above said, keep in mind that leverage can be a powerful tool for increasing your potential returns, but it can also be risky if you’re not careful.
By using analogies like a lever or a see-saw, and looking at simple examples like buying a house, hopefully you now have a better understanding of how leverage works with money.
As with any financial decision, it’s important to do your research, consult with a professional if you’re unsure, and never invest more than you can afford to lose.
