Leverage in Investing
Leverage is used every day, by both businesses and individuals. Any time money is borrowed to amplify results or invest in a future outcome, those funds are being leveraged.
How does leverage work? Chances are, you already have some leveraged investments without even realizing it. Learning how to use leverage ensures you make the most of this valuable investing tool. Read on to understand everything you need to know about leverage returns, including advantages, disadvantages and more.
What is Leverage?
Leverage is a term used in investing to describe the use of borrowed money to increase the returns on a specific investment or project. Financial leverage allows a business or brand to increase their buying power or to reinvest in their own operations. Brands use financial leverage in a variety of ways, depending on their specific needs and circumstances.
For investors, the ability to leverage debt means that more money can be invested. This can ultimately result in higher overall profits. One very common example of leverage is a home mortgage. This is a low risk way to leverage debt, as housing is generally a long term, stable investment.
How Leverage Works
Investment leverage can be used by both companies and individuals. The most common uses of leverage for personal investing includes the home mortgage, student loans and large purchases like automobiles. In each case, you're borrowing money to invest in a future event or purchase.
Debt leverage for businesses works in several ways, and really just depends on the needs and financial goals of the business. A newer business or brand may need to leverage investments to support growth - borrowing funds in order to increase output. This can help scale up the business without opting for outside investors. A more mature business that wants to learn how to increase leverage may take a different approach. For example, they may just want to invest in new markets or areas while still remaining a private company.
Leverage vs Margin
Learning the difference between leverage and margin is important when you’re learning how to leverage money.
When you use leverage, you’re borrowing money to make an investment or purchase.
Margin, by contrast, refers to the funds that are available to you from a broker to invest with. Margin investing carries more risk than simply leveraging investments.
Advantages of Leverage
There are several important advantages to using leverage for both personal investors and businesses. Used properly, leverage return can be of great benefit in a variety of ways.
- Leverage investment provides greater returns than you might be able to afford on your own.
- Leverage allows you to make large purchases you may otherwise not be able to afford. Homes, vehicles and education are all commonly funded with leveraged money.
- Leverage allows for more rapid growth. Whether you’re scaling up a business, or you’re trying to increase your own portfolio value, wise use of leveraged funds can move things along at a faster pace.
Disadvantages of Leverage
While leverage is beneficial in a number of ways, as with most things when it comes to investing, there are also some drawbacks to be aware of before you decide that you’re going to dip your toe into the world of leveraging. Some of the drawbacks can include:
- As with any investment, leverage presents some risk. Using this financial tool can backfire. You could end up owing money with nothing to show for it.
- Experts also warn that leverage amplifies losses. Since you’re investing more capital than you actually have, if the investment fails, the losses may be much larger than you might expect.
- Businesses investing in new inventory or equipment using leveraged funds may run into trouble if the market for their services changes. Even if business is down, borrowed funds will still need to be repaid.
Example of Leverage
A common scenario for new or small businesses includes leveraging money for future growth. When a business takes out a loan from the SBA or a bank to buy inventory, open a brick and mortar location or expand operations, they’re using leverage to spur growth and increase profits.
A more established business might borrow funds to introduce a new product or to invest in equipment that’ll boost productivity and efficiency.
Two specific examples of leverage would be:
- Financial Leverage: A company already has $10m from investors. They can get up and running with this money, but they may borrow another $10m to reinvest in the company to expand and grow.
- Leveraged Investing: An investor does what’s known as “buying on margin” where they use borrowed funds to gain access to more money. They then use the additional funds to invest with. This strategy gives investors the ability to control a bigger pool of assets with less money.
When you learn how to leverage money, you add a powerful tool to your investment portfolio. And of course, the more you learn about increased leverage, the better the chances are that you’ll be able to use this method wisely and to your best advantage.
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