Leverage is simply borrowing money to purchase investments, with the goal of achieving greater wealth.
Investment leverage, is borrowing to invest. We can utilize our resources and assets to acquire good debt (an investment debt that creates value), then we can expect exponential growth on our money. It is using someone else’s money to achieve your investment goals.
With traditional investing, you set aside a portion of your income each month to purchase investments and your investments gradually grow over a long period of time. With leveraged investing, you take out a loan and make a single large investment purchase on day one. Then, you set aside a portion of your income each month to make interest payments on the loan.
Example One: If you have cash on you, you can buy your own house fully paid for on cash. Say the house costs USD100 000 and you pay the full value. Suppose it appreciates in value and four years later you sell it for $150 000. So you made a profit or return on investments of $50 000 out of your original $100 000. That is a gross return of 50%. Now suppose you buy the same house using mortgage with a 20% down payment. It means you pay $20 000 of your own money to get a $100 000 house. Suppose you now sell the house at $150 000 four years later. You repay the loan ad interest say at $80000 loan and $20 000 interest. Your profit out of your initial investment of $20 000 is $30 000 which is 150% return on your initial investment. That is leverage. You get a better return on your funds faster. One could also use the balance of the $100 000 to get other investments. So anyone who gets a mortgage is using the principle of leverage.
Example Two: By leverage, we mean that the asset is being purchased with only a portion of the purchase price coming from the buyer and the balance coming from a lender. Suppose that the house in Example One was actually for rental purposes which means that the repayment is covered by the tenant. SO the tenant is paying for your house. In fact this is another form of leverage uses someone else resources to acquire you an asset. Therefore any increase in value of the entire house represents a real return on the original amount invested. In this theoretical case On selling the house you get a profit of $150 000 – $20 000 = $130 000. Since the $80 000 borrowed and its interest from bank is covered by the rentals. So your actual return on investment is about 650%. That is the power of financial leverage.
NB Obviously we have excluded other costs that will reduce the return on investments for simplicity like transfer fees, agency fees etc
Leverage is any technique that amplifies investor profits or losses. It’s most commonly used to describe the use of borrowed money to magnify profit potential (financial leverage), but it can also describe the use of fixed assets to achieve the same goal (operating leverage).
A friend and I decided to develop some real estate and at that time felt that we could not access bank loans. So we decided to partner on acquiring the land. We opted to develop some cluster homes. But since the banks where not amenable to finance the project because of a illiquid market. We used two forms of leverage as follows: Initially we used little money to renovate the existing structures and produced three units which we then sold to generate the starting capital for the project. Once we started on the project we sold some units as they were under construction. These funds enabled us to complete the sold units and start on other units which we then sold as completed. This way we used leverage of the pre-purchasers to deliver the whole project. I have simplified this process for explanatory power but one has to be cautious and not be tempted to divert parts of the inflow to personal use but t ensure that one delivers the correct and promised value to the pre-purchasers.
Fourth Example: As an entrepreneur you can be self employed and use all your effort and energy to deliver value to your clients. You are using your own time and energy. But of one was to find a way of employing other people to deliver the value and compensate tem well one would be using the principle of leverage in multiplying one’s productivity by leveraging the time, skills and competences of the people one has hired.
So leverage can accelerate your path to financial destiny. However a closer look at these examples shows that leverage has both advantages and disadvantages, So one has to be careful. Tomorrow we look at advantages and disadvantages of financial leverage.