Leverage

Leverage in finance refers to borrowing money to invest or purchase assets. It involves using a small amount of your own money and borrowing the rest to increase the potential return on investment.

Example #1

Imagine you want to buy a house worth $200,000. Instead of paying the full amount in cash, you put down $40,000 (20%) and borrow $160,000 (80%) from a bank. If the house value increases, your return on investment is calculated based on the total value of the house, not just the amount you put in.

Misuse

Misusing leverage can be risky, especially if investments don't perform as expected. For example, if the value of the house mentioned earlier drops below the loan amount, you could end up owing more than the property is worth. This situation can lead to financial difficulties, especially if you're unable to cover the loan repayments.

Benefits

Leverage can amplify returns when investments perform well. Using the same house example, if the property value increases to $250,000, the profit realized after paying off the loan would be higher than if you had paid fully in cash, leading to a higher return on investment.

Conclusion

It's important for consumers to understand the risks involved in leveraging investments. While it can magnify gains, it also magnifies losses if investments underperform. Consumers should consider their financial situation, risk tolerance, and seek professional advice before engaging in leveraged investments.

Related Terms

AssetsLiabilitiesDebtRisk Management