What is Leverage?

Leverage is the Financial Too that Intelligent Investors use to magnify their return on Investments. Leverage is like Double edged Sword. Means if everything goes fine, it will magnify your profits & if something goes wrong than it will magnify your losses as well….

Investopedia Says;

1. The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.

2. The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged.

Leverage is most commonly used in real estate transactions through the use of mortgages to purchase a home.

Leverage in Simple Language -

Example: 1 Let us discuss in the layman’s language that, What is Leverage? Well, suppose you have 1000 Rupees in your pocket. Now with the 1000 rupees you can buy 100 stocks of the Company having its market value Rs.10 each.

So now in case of 10% gain in the stock price (Means the stock price moves up to Rs.11 per stock), your over all profit will be Rs.100 and thus it will become Rs.1100.

Now suppose you have taken Leverage. Means you have used the Futures & Options. So it means that you have put Rs.1000 as a margin money and borrowed (Leveraged) Rs.9,000 from Bank. So now from the Total 10,000 Rupees you will be able to buy 1000 stocks of that Company instead of 100 only. So in case of 10% gain in the stock price will make you a profit of Rs.1000 instead of Rs.100 in the previous scenario.

This is the power of Leverage. It can magnify your Profits (and Loss well). So your over all return on Investment in first scenario will be 10% (Rs.100) and 100% (Rs.1000) in the second scenario.

Example: 2 Now let us discuss the another scenario. Leverage is most commonly used in buying a Home. Say for Example, you are a Real Estate Investor. Now you put Rs.1,00,000 (1 Lakh) as a down payment and borrow (Leverage) Rs.9,00,000 (9 Lakhs) from a Bank to buy the Residential Property of Rs.10 Lakhs.

So now because of the Leverage, you will be able to hold the Asset (Residential Apartment) of Rs.10 Lakhs with only Rs.1 Lakh…. Now you put that Apartment on Rent and divert your rental income towards paying the mortgage and interest of your property. So your Tenant will pay that Mortgage and not you.

Now suppose the property price doubles after 5 years. So it will become Rs.20 Lakhs. And by that time you have paid the mortgage. So now you own a while property of Rs.20 Lakh from just Rs.1 Lakh of Investment only 5 years back. In shirt, The Leverage has magnified your profit. This is the power of Leverage.

Intelligent Investors use Leverage in their favour to become more richer over the time.

Bad Leverage -

Well, Leverage means Borrowed Money. Now Leverage is not all the time Good. You have to buy Assets (Stocks, Real Estate, Businesses…etc) out of the Borrowed Money than and only it will work in favour of you.

What most of the people do is, they use leverage to buy Depreciating items such as Car, Clothes, Electronics, Tours & Travels……etc……. All of these things are depreciating so Leverage will work here but not in favour of you but in favour of your Banker………….

So always use your Financial IQ before taking Leverage………..

I am sure that, after reading this Article, your Financial IQ won’t be the same but it must have been increased……..!!!!!!!!!!