"Leverage Cuts Both Ways, So Be Careful Using It"
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What is leverage
The word leverage comes from the basic tool called a lever.
When you use a lever, you in effect multiply your effort. Even though you cannot directly move a large stone with the strength in your arms, the lever multiplies your strength so you can move that large stone.
One good example of financial leverage is your home mortgage
Let's say you paid a $10,000 down payment when you bought your house for $200,000.
Leverage allowed you to move into a house worth $200,000 for only $10,000.
Of course, you still have to pay the mortgage on the other $190,000, but you still have full use of the entire $200,000 house.
Also, when real estate prices go up in your neighborhood, the value of your houses rises in its entirety
That is, when home prices go up by 10%, your entire house is worth more by 10%, not just the part you have actually paid for.
So if your house goes up in value 10% in a year -- it's now worth $220,000.
In effect, your original $10,000 down payment has multiplied itself by 3.
When you bought the house, you had $10,000 equity in it:
200,000
-190,000 (the mortgage you owe)
---------
$10,000 equity (since that the amount of your down payment)
Now you have:
220,000
-189,000 (the mortgage you owe)
--------
$31,000 equity
I'm assuming that during the year you paid $1,000 on your mortgage principal through making your monthly payments.
Your equity increased by $1,000 through the flat paying of your monthly mortgage payments.
Your equity increased by another $20,000 through the rise of real estate prices that affected your entire house, and which benefited you entirely.
That's the positive power of leverage investing
There is a dark side, however -- the risk of the leveraged investment's value going down.
Let's assume now that property prices in your neighborhood actually declined 10% in the first year. What happens?
180,000
-189,000
--------
-$9,000 (you owe more than the house is worth, even though you paid off $1,000 of your mortgage's principal)
Yes, your equity in the house has gone from $10,000 to MINUS $9,000.
Just as you were disproportionately (relative to what you paid on the mortgage) rewarded by the increase in value, a decrease in value similarly punishes you.
However, when you buy a house to live in, your main concern is to have a place for you and your family to live. As long as you still want to stay in that neighborhood in that house, you don't have a problem.
With other leveraged investments, however, you will feel pain if you use market leverage and lose
Some people buy stocks on margin. If your brokerage allows you, you can borrow money from them to buy stocks for 50% down. That is, if you'll put up $1000 in your own cash, the brokerage will lend you another $1000 so you can buy 100 share of XYZ Co at $20 per share -- a total of $2000.
(The brokerage does not do this for free -- they do charge interest, which can be a factor in whether or not you make money by doing this, but I'm sticking with explaining leveraging your investments.)
So you've now got the benefit of owning 100 shares of XYZ Co worth $2000 by paying only $1000 out of your pocket.
You have:
$2,000
-$1,000 (you owe to the brokerage)
-------
$1,000 net equity in your account
But we know that stock prices rise and fall
If in a month, XYZ Co is at $30, you feel good. Your 100 shares are now worth $3000.
Your $1000 doubled in a month!
$3000
-$1000 (the amount you still owe to the brokerage)
------
$2,000 net equity in your account
But what if XYZ Co goes down to $10?
$1,000
-$1,000 (you owe to the brokerage)
-------
$0 net equity
Your cell phone's ringing . . . it's your broker calling to tell you they're liquidating your account!
Notice something important -- If you had simply bought 50 shares with your $1000, you would still have $500 worth of stock. A painful loss, certainly, but something. But since you bought on margin, you multiplied your loss.
In income investing, you should not use asset leverage
Market leverage is risky, as you can see. Unless you have a crystal ball or inside information (which of course is illegal), don't use leveraged financial investments.
Unfortunately, some money managers do use a leverage strategy to multiply the yield they pay you. If you are not aware of leverage costs and its risks, or you don't know that a certain mutual fund or other investment uses leveraged securities to boost returns, you may not understand the risk your money faces.
Next, you must understand that there's a certain amount of danger in all types of investments: Risk
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