What is Leverage?

In today's episode of “Saving and Investing”, Michael Fischer explains a concept I've heard mentioned a lot, but have never understood. The term “leverage” is used in many financial books and articles, often referring to real estate investments. The concept has always puzzled me, even when I looked it up. Michael's explanation is short and to the point. Leverage makes perfect sense now.


What is leverage? (2:48)

 

A simple example of financial leverage: Say you have $10 that you want to invest in a stock. If you invest that $10 and it goes up 10%, you've made $1. However, if you're able to borrow an additional $90 to purchase that stock, you'd have $100 total to invest. If that stock goes up 10%, you've made $10. This is leverage: borrowing money to magnify returns. (Of course, losses are magnified as well.)


Principles of leverage (3:25)

 

A home mortgage is a common example of leverage in practice. In general, a homebuyer has only a small amount of the purchase price. Most of the money for the transaction is borrowed from a bank. House prices tend to increase with time. By using leverage to purchase a house, we're able to magnify our return on equity.

Why do I like Michael's video series so much? (And make no mistake: I love it. I'm learning a lot.) Because he's able to present these financial concepts clearly, in a way that makes sense. Compare his succinct definition of leverage to the definition at Investopedia:

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.

Huh?

On Monday, Michael explains financial statements. Then he dives into stocks, bonds, and financial markets!

More about...Investing

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