What is leverage? How investors can use debt to increase the returns on investments
- Leverage is when you use borrowed funds to increase the potential return of an investment.
- Leverage is used by professional traders, individuals who are making big-ticket purchases, entrepreneurs, and investors.
- While leverage can help compound your returns, it can also compound your losses.
We've all heard it before: Debt is bad. But that isn't always the case. Debt can sometimes be used to build credit, start building equity through the purchase of a new home - or even by leveraging it to make an investment that may yield a profit. Leveraging is when you tap into borrowed money - such loans, securities, capital, or other assets - for an investment with the intention to potentially increase the return of said investment.
Here's what you need to know about what leverage is, how it works, and how it's used among business owners, investors, and everyday people looking to turn a profit.
What is leverage?
Leverage in an investment strategy that involves tapping into borrowed capital to bolster the potential return of an investment. It can be used in the realms of business, professional trading, or to finance a house. Leverage can also refer to how much debt a particular company uses to fund an asset, which is known as financial leverage.
While leverage might increase the returns of an investment, there's a downside: Should an investment not work out, it could also increase the potential risk and loss of an investment.
"While leverage can magnify returns if someone can earn more on the borrowed funds than what they cost, the opposite is true," says Robert R. Johnson, a professor of finance at the Heider College of Business at Creighton University. "Leverage [also] magnifies losses when one earns less on the borrowed funds than [what they] cost."
How leverage works
Leverage is when you tap into borrowed capital to invest in an asset that could potentially boost your return. For example, let's say you want to buy a house. And to buy that house, you take out a mortgage. By loaning money from the bank, you're 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 corporations and founders of startups, businesses of all sizes, professional traders, and everyday individuals. Essentially, anyone who has access to borrowed capital to boost their returns on the investment of an asset uses leverage.
"When making a purchase, investors can use a combination of both their own equity capital and leverage to expand the affordability of any investment," says Keith Carlson, CEO and managing partner of Roebling Capital Partners. "Simply put, debt and equity availability will always be greater than equity alone; what one can purchase using both will always be more substantial."
Leverage also works for investors in bolstering their buying power within the market-which we'll get to later.
Types of leverage
There are four main ways leverage can be used:
Financial leverage: A business can tap into leverage by way of taking out loans or issuing bonds. This can be more beneficial for a company that doesn't have a lot of assets or wants to avoid having to sell the company's equity to raise money. And in turn, leverage can be used to do a number of things: expand operations, buy inventory, materials, or equipment, or to kick-start new ventures.
This is called financial leverage, which is when a company takes on debt to buy assets that it expects to yield profits that will exceed the cost of what it borrowed. Debt-to-income ratio is used to calculate a company's financial leverage to help potential investors determine whether the company is a risk or valuable investment worth making.
"A corporation can utilize leverage to build shareholder wealth in the business sector, but if it fails to do so, interest expense and the chance of failure destroys the shareholder value," says Jonathan Saedian, a CEO and founder of Initiate.AI. "While it increases the buying power of an investor by allowing them to make increased gains with the use of more buying power, it also increases the risk of having to cover the loan."
Leveraged investing: Investors can use leverage to bolster their buying power. Professional traders do what's called "buying on margin" to use borrowed funds to have more money to invest in. In turn, it can lead to greater returns. When you buy on margin, you draw from loaned money to buy securities in a margin account. With margin accounts, you can make larger investments with money you borrow.
"Investors can use margin to control a larger pool of assets with a smaller amount of money," says Johnson. "In the stock market, investors can control $100,000 worth of securities with $50,000."This means you use less of your own personal money. While it compounds your gains, it can also compound your losses.
However, buying on margin can be tricky, complicated, and fast-moving, and there are great risks involved. In some cases, investors may lose far more money than they initially put in. "If you try to magnify your returns by using leverage, you may not have the financial wherewithal to withstand the interim volatility before the wisdom of your decisions pan out," says Johnson.
Quick tip: Note that buying on margin is a strategy that's typically reserved for aggressive, experienced investors, as there's great risk involved. Newer, inexperienced investors are generally advised not to buy on margin.
Using leverage for personal finances: While leverage is often associated with investing, individuals also use leverage to make big-ticket purchases. When people take out a loan to purchase an asset or with the hopes of growing their money in the future, they are using leverage.
For instance, if you take out a loan to invest in a side business, the investment you pour into your side business helps you earn more money than if you didn't pursue your venture at all.
Leverage in professional trading: To dramatically increase their purchasing power, professional traders often take on a more aggressive approach to leverage, and take on higher levels of borrowed capital for even more significant returns to an everyday investor.
Professional investors often have higher limits on the borrowed capital and don't go by the same requirements as non-professionals. Again, as the gain and risk can be substantially higher, this is for the 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 off the ground with $3 million from angel investors. Should the startup borrow $7 million, there's now $10 million total to put into running the business. Furthermore, there's also greater opportunity to boost its value to shareholders.
For example, within brokerage margin accounts, a 2:1 ratio is often used, explains Brian Stivers, an investment advisor and founder of Stivers Financial Services. Stivers provides the following example: You can purchase $10,000 in stock by putting $5,000 of your own money into the account, and borrowing the other $5,000 from the broker using the stock and cash as collateral.
"Let's say the value of the stock rose 30%, and you sold the stock for $13,000," says Stivers. "You would then pay the broker back $5,000 leaving you with $8,000. So, you made a $3,000 profit on your $5,000, which is a 60% gain. Had you just purchased $5,000, you would have only increased your value by $1,500 for a 30% gain."
As you can see, using leverage enabled you to purchase more of the desired stock and enjoy greater gains. "But beware, if the value of the stock goes down you are also exponentially increasing your loss potential as well," says Stivers.
Leverage vs. margin
While leverage and margin are similar, there are some major differences between the two:
- Leverage is the practice of actually receiving a loan from a bank or lending institution for specific purposes, explains Saedian.
- 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 enables you to 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 a mortgage, this is not considered margin, it is leverage."
- When you use leverage, there is an actual cash disbursement for specific purposes. With margin, on the other hand, no cash is disbursed. However, the strategy is used to achieve a similar outcome and you're using someone else's money to obtain an asset with the hope of increasing your return.
- With margin trading, the investor borrows money from their broker to buy securities such as bonds and stocks.
The financial takeaway
Leverage is a common strategy where a person or company uses borrowed money to invest and potentially grow an investment with the expectation of turning a profit. It can be used in a number of ways: to help kick-start or expand a business, to increase shareholder wealth, to buy a home or attend college, or when investing in the stock market.
While leverage can increase one's return, it can also increase the losses of an investment. By understanding the risks involved, it can help you decide whether using leverage is the right choice for you and your finances, and for what types of investments.