What is leverage? Definition, example and formula

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  • Leverage is the use of borrowed funds to increase the potential return of an investment.
  • Leverage is used by professional traders, individuals who make large purchases, entrepreneurs and investors.
  • While leverage can help make your returns worse, it can also make your losses worse.

We’ve all heard it before: Debt is bad. But it’s not always the case. Debt can sometimes be used to build up credit, start building equity through the purchase of a new home – or even use it to make an investment that can generate a profit. Leverage is the act of drawing down borrowed money – such as loans, securities, capital or other assets – for an investment with the aim of potentially increasing the return on said investment.

Here’s what you need to know about what leverage is, how it works, and how it’s used by business owners, investors, and everyday people looking to make a profit.

What is leverage?

Leverage in an investment strategy that involves drawing on borrowed capital to enhance the potential return of an investment. It can be used in the field of business, professional trade or to finance a house. Leverage can also refer to the amount of debt a particular company uses to finance an asset, which is known as financial leverage.

Although leverage can increase an investment’s returns, there is a downside: if an investment does not perform, it could also increase the potential risk and loss of an investment.

“Although leverage can amplify returns if someone can earn more on borrowed funds than they cost, the reverse is true,” says Robert R. Johnson, professor of finance at Heider College of Business from Creighton University. “Leverage [also] amplifies losses when one earns less on borrowed funds than [what they] Cost.”

How Leverage Works

Leverage involves tapping into borrowed capital to invest in an asset that can increase your return. For example, let’s say you want to buy a house. And to buy that house, you take out a mortgage. By lending money to the bank, you are essentially using leverage to buy an asset – which in this case is a house. Over time, the value of your home could increase.

Leverage is used by entrepreneurs such as CEOs of companies and founders of startups, businesses of all sizes, professional traders and individuals. Essentially, anyone who has access to borrowed capital to increase their return on investing an asset is using leverage.

“When making a purchase, investors can use a combination of their own equity and leverage to increase the affordability of any investment,” said Keith Carlson, CEO and Managing Partner of Roebling Capital Partners. “Put simply, the availability of debt and equity will always be greater than equity alone; what can be purchased using both will always be more substantial.”

Leverage also works for investors by increasing their buying power in the market – something we’ll get to later.

Types of lever

There are four main ways to use leverage:

Financial leverage: A company can take advantage of leverage by taking out loans or issuing bonds. This may be more advantageous for a company that does not have a lot of assets or wants to avoid having to sell the company’s equity to raise funds. And in turn, leverage can be used to do a number of things: expand operations, buy inventory, materials, or equipment, or start new businesses.

This is called financial leverage, which is when a company goes into debt to buy assets from which it expects to generate profits that will exceed the cost of what it she borrowed. The debt ratio is used to calculate a company’s financial leverage to help potential investors determine whether the company represents a risk or a valuable investment worth making.

“A company can use leverage to create wealth for its shareholders in the corporate sector, but if it doesn’t, interest costs and the risk of failure destroy shareholder value,” says Jonathan Saedian, CEO and Founder of Initiate.AI. “While this increases an investor’s purchasing power by allowing them to make increased gains by using more purchasing power, it also increases the risk of having to cover the loan.”

Debt Ratio Formula (DE)

Alyssa Powell / Insider

Leveraged investment: Investors can use leverage to enhance their buying power. Professional traders do what is called “margin buying” to use borrowed funds to have more money to invest in. In turn, this can lead to higher returns. When you buy on margin, you use loan money to buy securities in a margin account. With margin accounts, you can make larger investments with the money you borrow.

“Investors can use margin to control a larger pool of assets with a smaller amount of money,” Johnson explains. “In the stock market, investors can control $100,000 worth of securities with $50,000.” This means that you use your personal money less. Although it makes your winnings worse, it can also make your losses worse.

However, buying on margin can be tricky, complicated and fast, and involves great risk. In some cases, investors can lose a lot more money than they initially put in. says Johnson.

Using leverage for personal finance: Although leverage is often associated with investing, individuals also use leverage to make large purchases. When people take out a loan to buy an asset or in hopes of making their money grow in the future, they are using leverage.

For example, if you take out a loan to invest in a side business, the investment you make in your side business helps you earn more money than if you didn’t continue your business at all.

Leverage in professional trading: To dramatically increase their buying power, professional traders often take a more aggressive approach to leverage and accept higher levels of borrowed capital for even greater returns for an ordinary investor.

Professional investors often have higher limits on borrowed capital and are not subject to the same requirements as non-professionals. Again, as the payoff and risk can be considerably higher, this caters to pros with a different level of knowledge, depth of experience, and comfort level with risk.

Example of leverage in investing

Let’s say a startup got started with $3 million from angel investors. If the startup borrows $7 million, there is now a total of $10 million to invest in running the business. In addition, there is also a greater opportunity to increase its shareholder value.

For example, in margin brokerage accounts, a 2:1 ratio is often used, says Brian Stivers, investment advisor and founder of Stivers Financial Services. Stivers gives the following example: You can buy $10,000 in stocks by putting $5,000 of your own money in the account and borrowing the remaining $5,000 from the broker using the stocks and the cash as collateral.

“Let’s say the stock went up 30% in value and you sold it for $13,000,” Stivers says. “You would then refund $5,000 to the broker, leaving you with $8,000. So you made a profit of $3,000 on your $5,000, a gain of 60%. If you had just bought $5,000, you would only have increased your value by $1,500 for a 30% gain.”

As you can see, the use of leverage allowed you to buy more of the desired shares and achieve greater gains. “But beware, if the stock’s value goes down, you’re also exponentially increasing your potential loss,” Stivers says.

Leverage vs Margin

Although leverage and margin are similar, there are major differences between the two:

  • Leverage is the practice of receiving a loan from a bank or credit institution for a specific purpose, Saedian explains.
  • Margin is specific to investing in other financial instruments, says Shanka Jayasinha, chief investment officer of S&J Private Equity. “For example, a margin account lets you borrow money from a broker for a fixed interest rate,” says Jayanisha. “With this, you can invest in leveraged securities. On the other hand, if you were to take out a mortgage, that’s not considered margin, it’s leverage.”
  • When using leverage, there is an actual cash disbursement for a specific purpose. With the margin, on the other hand, no cash is disbursed. However, the strategy is used to achieve a similar result and you are using someone else’s money to obtain an asset in hopes of increasing your return.
  • With margin trading, the investor borrows money from their broker to buy securities such as bonds and stocks.

The bottom line

Leverage is a common strategy in which a person or business uses borrowed money to invest and potentially grow an investment in hopes of making a profit. It can be used in many ways: to help start or grow a business, to increase shareholder wealth, to buy a house or go to college, or to invest in the stock market.

Although leverage can increase a person’s return, it can also increase an investment’s losses. Understanding the risks involved can help you decide if using leverage is the right choice for you and your finances, and for what types of investments.