One of the most important concepts in finance is financial leverage. It helps businesses and investors understand how to use borrowed money to increase potential returns. This article will explain what financial leverage is, how it works, the different types of leverage, how to calculate it, and the pros and cons of using financial leverage.
What is financial leverage and how does it work?
Imagine using a lever to lift something heavy with less effort. In finance, leverage means using borrowed money debt to invest in assets. This borrowed money acts like the lever, allowing you to make a bigger investment than you could with just your own money.
How does financial leverage work?
- Using borrowed money: An investor or business takes a loan or borrows money.
- Investing in assets: This borrowed money is combined with their funds to invest in something bigger, like buying more stock, property, or equipment.
- Increasing potential gains: If the investment goes well, the gains could be much higher because the initial investment was larger due to the borrowed funds.
For example, if you have $10,000 and borrow another $10,000, you can invest $20,000. If this investment grows by 10%, you earn $2,000. Without borrowing, your gains would have only been $1,000.
Risks of financial leverage:
Just like a lever can make lifting easier, it can also make things riskier. If the investment loses value, you still have to repay the borrowed money. This means your losses can be larger, too. For instance, if your $20,000 investment drops by 10%, you lose $2,000. Without borrowing, your loss would have been just $1,000.
Types of leverage
1. Day trading leverage
Day traders buy and sell stocks, cryptocurrencies, commodities or whichever asset they prefer within the same day, aiming to profit from small price changes. They often use leverage to increase their buying power.
- How it works: A trader might have $1,000 but uses leverage to trade $4,000 worth of stocks, cryptocurrencies, commodities or whichever asset they prefer. For instance, they might consider trading movements in the silver price, nickel price or palladium price online.
- Benefit: If the asset price goes up, the trader makes more profit than they would with just their own money.
- Risk: If the stock price goes down, the trader also faces larger losses and must repay the borrowed amount.
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2. Futures market leverage
In the futures market, investors agree to buy or sell an asset at a future date for a set price. Leverage is used to control a large position with a relatively small amount of money.
- How it works: An investor might put down a small percentage of the total contract value (called a margin) but control a much larger position.
- Benefit: This allows for potentially large gains if the asset's price moves in the investor's favor.
- Risk: If the price moves against the investor, losses can be substantial and exceed the initial margin.
3. Real estate leverage
Investors use leverage in real estate by taking out a mortgage to buy property.
- How it works: An investor might use $20,000 of their own money and borrow $80,000 to buy a $100,000 property.
- Benefit: If the property value increases, the investor can make a significant profit compared to their initial investment.
- Risk: If the property value decreases or rental income is lower than expected, the investor still has to repay the mortgage, leading to potential losses.
4. Business leverage
Businesses use leverage to finance their operations and growth by taking loans or issuing bonds.
- How it works: A company borrows money to invest in new projects, equipment, or expand operations.
- Benefit: Successful investments can lead to higher profits and business growth.
- Risk: If the investments don't pay off, the business still needs to repay the debt, which can lead to financial difficulties.
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Pros and cons of financial leverage
| Pros of financial leverage | Cons of financial leverage |
|---|---|
| Potential for increased gains: Leverage allows you to make bigger investments. If these investments do well, your gains could be much higher than if you used only your own money. For example, borrowing money to invest $20,000 instead of $10,000 could double your gains if the investment increases in value. | Potential for bigger losses: Just as leverage could amplify gains, it could also amplify losses. If your investment loses value, your losses will be greater because you have to repay the borrowed money. For instance, a 10% loss on a $20,000 investment (including borrowed funds) results in a bigger hit than if you only invested your own $10,000. |
| More opportunities: Using leverage, you could seize more investment opportunities. This is especially useful for small businesses looking to grow quickly by buying more stock or equipment than they could afford with just their own funds. | Debt repayment: Regardless of your investment's performance, you must repay the loan with interest. This could be a financial burden if the investment doesn’t generate enough gains. |
| Tax benefits: Sometimes, the interest you pay on borrowed money could be deducted from your taxes. This could reduce the overall cost of borrowing and make leveraging more attractive. | Risk of bankruptcy: High levels of debt could lead to financial instability and even bankruptcy if you can't meet your repayment obligations. This risk is especially high if investments don’t perform as expected, putting you in a tough financial position. |
Summary
In summary, financial leverage could help you earn more financial gains and perhaps expand your investment opportunities, but it also comes with significant risks. It's important to use leverage carefully and understand the potential downsides.
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