Leverage Part 1: What is Leverage?

Leverage: Think of it as using “other people’s money” to make money more quickly. Probably another topic that is best explained with an example.

Greg has $1,000 a year to invest for 10 years. Assuming a rate of return of 10%, at the end of 10 years he will have $17,531.

BUT, we know from the post on the magic of compound growth that TIME has a large effect on growth.  The philosophy is that if you could instead take all that $10,000 over 10 years and just put it in now, you will have more money than by putting it in over 10 years.

Okay, let’s look at a simple use of leverage: Greg only has $1,000/year, so he can afford a loan payment of $83.33/month (That’s $1,000 per year). First we have to figure out how much of a loan he can get. Assuming a 6% interest rate, $83.33/month for 120 months (10 years) will allow him to borrow $7,530.89. So he isn’t starting with $10,000 since we have to compare apples to apples (in the form of how much cash flow he is willing to dedicate to his investment savings).

Okay, so now let’s calculate how much $7,530.89 will grow to if invested and assuming the same 10% rate of return… My trusty financial calculator tells me $19,533. So in this case he has roughly $2,000 MORE through the leverage than with the yearly savings (which yielded him $17,531).

Now before you go out and get a loan to invest, remember that a lot of people get burned on leverages – as they magnify RISK as well as return. In Part II of “Leverage” I’m going to look at a negative scenario.

You know, the topic of leveraging is a big one – I envision that I could easily write a 10 part series of posts on it, and probably will. It’s glamorous, but please make sure to consult with a professional before getting one! This post is in no way meant to be taken as advice to get an investment loan.

Having said that, if you own a house and have a mortgage – you already have a leveraged investment! :) You have borrowed money to buy an appreciating asset.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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