Leverage is nothing more or less than using borrowed money to invest. Leverage can be used to help finance anything from a home purchase to stock market speculation. Businesses widely use leverage to fund their growth, families apply leverage—in the form of mortgage debt—to purchase homes, and financial professionals use leverage to boost their investing strategies.
What Are the Different Kinds of Leverage?
Leverage has slightly different meanings in personal finance, investing and business. But in each case, leverage is the use of debt to help achieve a financial or business goal. There are four main types of leverage:
1. Leverage in Business
Businesses use leverage to launch new projects, finance the purchase of inventory and expand their operations.
For many businesses, borrowing money can be more advantageous than using equity or selling assets to finance transactions. When a business uses leverage—by issuing bonds or taking out loans—there’s no need to give up ownership stakes in the company, as there is when a company takes on new investors or issues more stock.
Leverage can be especially useful for small businesses and startups that may not have a lot of capital or assets. By using small business loans or business credit cards, you can finance business operations and get your company off the ground until you start earning profits. When you take out a loan or a line of credit, the interest payments are tax-deductible, making the use of leverage even more beneficial.
When evaluating businesses, investors consider a company’s financial leverage and operating leverage.
Financial leverage signifies how much debt a company has in relation to the amount of money its shareholders invested in it, also known as its equity. This is an important figure because it indicates if a company would be able to repay all of its debts through the funds it’s raised. A company with a high debt-to-equity ratio is generally considered a riskier investment than a company with a low debt-to-equity ratio.
Operating leverage, on the other hand, doesn’t take into account borrowed money. Rather, it’s a company’s ratio of fixed costs to variable costs. Companies with high ongoing expenses, such as manufacturing firms, have high operating leverage. High operating leverages indicate that if a company were to run into trouble, it would find it more difficult to turn a profit because the company’s fixed costs are relatively high.
2. Leverage in Personal Finance
When it comes to your personal finances, you may be surprised at how often you use leverage. Whenever you borrow money to acquire an asset or potentially grow your money, you’re using leverage. You might use leverage when you do the following:
- Buy a home: When you purchase a house with a mortgage, you are using leverage to buy property. Over time, you build equity—or ownership—in your home as you pay off more and more of the mortgage. This is how you earn a return on your investment in your home.
- Take out student loans: When you borrow money to pay for school, you’re using debt to invest in your education and your future. Over time, your degree boosts your earning potential. Higher salary lets you recoup your initial debt-financed investment.
- Purchase a car: If you need to buy a car, you can purchase with a car loan, a form of leverage that should be used carefully. Cars are depreciating assets, meaning they lose value over time. But you generally buy a car to provide transportation, rather than earn a nice ROI, and owning a car may be necessary for you to earn an income.
Before using leverage in your personal life, be sure to weigh the pros and cons. Going into debt can have serious consequences if you can’t afford to repay what you borrow, like damaging your credit or leading to foreclosure.
3. Leverage in Investing
Leverage can offer investors a powerful tool to increase their returns, although using leverage in investing comes with some big risks, too. Leverage in investing is called buying on margin, and it’s an investing technique that should be used with caution, particularly for inexperienced investors, due its great potential for losses.
Buying on Margin
Buying on margin is the use of borrowed money to purchase securities. Buying on margin generally takes place in a margin account, which is one of the main types of investment account.
In a margin account, you can borrow money to make larger investments with less of your own money. The securities you purchase and any cash in the account serve as collateral on the loan, and the broker charges you interest. Buying on margin amplifies your potential gains as well as possible losses. If you buy on margin and your investment performs badly, the value of the securities you’ve purchased can decline, but you still owe your margin debt—plus interest.
In general, you can borrow up to 50% of the purchase price of margin investments. That means you can effectively double your purchasing power.
If the value of your shares fall, your broker may make a margin call and require you to deposit more money or securities into your account to meet its minimum equity requirement. It also may sell shares in your margin account to bring your account back into good standing without notifying you.
Leveraged Exchange-Traded Funds (ETFs)
You can use leverage in investing outside of a margin account as well. Leveraged exchange-traded funds (ETFs) use borrowed funds to try and double or even triple gains in their benchmark indexes
That means if an index rose 1% in a particular day, you might gain 2% or 3%. Of course, the opposite is also true. With leveraged ETFs, a 1% decline suddenly magnifies to 2% to 3%. It’s important to note that on most days, major indexes, like the S&P 500, move less than 1% in either direction, meaning you generally won’t see huge gains or losses with this kind of fund.
Leveraged ETFs are self-contained, meaning the borrowing and interest charges occur within the fund, so you don’t have to worry about margin calls or losing more than your principal investment. This makes leveraged ETFs a lower risk approach to leveraged investing.
That said, leveraged ETFs are still speculative, short-term investments—most people hold them for no more than a few days—and they often carry much higher expense ratios than index funds simply seeking to track market performance.
Using Debt to Invest
While leverage in personal investing usually refers to buying on margin, some people take out loans or lines of credit to invest in the stock market instead.
Because it can take a while to save enough money to meet some brokerages’ or mutual funds’ investment minimums, you might use this approach to get a lump sum to build a portfolio right away. (That said, many brokerages and robo-advisors now allow you to purchase fractional shares of funds, bringing down investment minimums to as low as $5—or even $1.)
Some of the most common debt-based investing strategies are:
- Take out a home equity loan: Some people tap into their home equity and take out a home equity loan or home equity line of credit (HELOC) to get money to invest. With this approach, they can get a lump sum of cash to invest as they wish. This is a risky approach, though, because not only do you risk losing money if your investment values fall, but you also jeopardize your home if you fall behind on payments.
- Apply for a personal loan: If you have good credit, you may qualify for a low-interest personal loan to get cash to invest. Personal loans are typically unsecured, so you don’t have to use the property as collateral. But they do charge interest and have relatively short repayment terms, meaning your investment would have to earn at least enough to cancel out the interest you’d accrue quickly.
- Use a credit card cash advance: If you have a low-interest credit card, you can take out a cash advance and invest the money. However, cash advances are usually subject to a higher APR than purchases and often have cash advance fees, too. With the high APR, you’d need to earn significant returns to make this approach worthwhile.
4. Financial Leverage in Professional Trading
Professional investors and traders take on higher levels of leverage to more efficiently use the money they have to invest.
Using leverage gives professionals more flexibility in directing the money they have to invest. With leverage, they can drastically increase their purchasing power (and associated returns) and potentially invest in more companies at one time using smaller amounts of cash and larger amounts of debt.
Traders also aren’t limited to the same requirements as average investors. For example, depending on the Forex broker a trader uses, they could request orders of 500 times the size of their deposit. That discrepancy between cash and margin can potentially increase losses by huge orders of magnitude, leaving it a strategy best left to very experienced traders.
The Bottom Line
Borrowing money allows businesses and individuals to make investments that otherwise might be out of reach, or the funds they already have more efficiently. For individuals, leverage can be the only way you can realistically purchase certain big-ticket items, like a home or a college education.
While leverage affords plenty of potential for upside, it can also end up costing you drastically more than you borrow, especially if you aren’t able to keep up with interest payments.
This is particularly true if you invest funds that aren’t your own. Until you have experience—and can afford to lose money—leverage, at least when it comes to investing, should be reserved for seasoned pros.