Leverage
What is Leverage?
Leverage is using borrowed money to increase the potential return of an investment.
It magnifies both gains and losses: a small price move produces a large percentage change on the invested capital. Excessive leverage makes firms and households fragile, a key factor in financial crises.
Leverage: a worked example
Maya buys a $200,000 rental property with $50,000 of her own cash and a $150,000 loan, so her assets are four times her equity. Suppose the property gains 10%, to $220,000. She sells, repays the $150,000 and walks away with $70,000: a 40% return on the $50,000 she put in, from a 10% move. Charge $6,000 of interest for the year and her profit is $20,000 minus $6,000 = $14,000, still 28%. Now run it the other way. A 10% fall to $180,000 leaves her $30,000, a 40% loss, and a 25% fall to $150,000 erases her equity entirely.
The mistake students make with leverage
Borrowing gets described as a way to raise returns, full stop. It raises returns only when the asset earns more than the interest on the debt, and it enlarges losses by exactly the same multiple in the other direction. Maya's four to one structure turns every 1% move in the property into a 4% move in her equity, up or down, and it adds a wipeout point that an all cash buyer never faces. The winning version of the story gets retold most often, which is why the risk half is easy to forget.
Leverage questions
Does borrowing money increase your investment returns?
Borrowing increases returns only when the asset earns more than the cost of the debt, and it multiplies losses whenever it does not. A buyer who funds a quarter of a purchase with equity turns a 10% asset gain into a 40% equity gain, and a 10% asset loss into a 40% equity loss. The interest bill is owed in either case, which is why debt raises expected return far less than it raises risk.
What is a margin call?
A margin call is a broker's demand for more cash when the equity in a borrowed position falls below a required minimum. An investor who buys $20,000 of stock with $10,000 of cash and $10,000 of margin debt starts at 50% equity. If the position falls to $13,000, equity is $13,000 minus $10,000 = $3,000, or 23%, below a 30% maintenance requirement. Restoring 30% of $13,000 means depositing $900, and failing to do so lets the broker sell at the worst possible moment.
Can you lose more than you invest?
Leverage is what makes losing more than you invested possible. An unleveraged buyer of shares can lose at most the purchase price. A borrower cannot: if Maya's $200,000 property falls to $130,000, the sale fails to cover her $150,000 loan and a recourse lender can still pursue her for the $20,000 shortfall. Margin accounts and short positions share that feature, which is why lenders demand collateral and set maintenance limits.
Related terms
Common comparisons
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