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.

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.)

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!