LEVERAGE AND THE FINANCIAL SYSTEM RICK TOBIN
What is Leverage?
Per the financial website entitled
“Investopedia”, some of the root definitions
for the word “Leverage” translate as follows:
“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.
3. Leverage is most commonly used in real estate transactions through the use of mortgages to purchase a
home.”
Leverage Can be Good or Bad Depending upon the Financial Cycles
When assets are appreciating in value such as stocks or real estate, then using third party money sources (i.e.,
margin loans, mortgages, credit lines, etc.) to buy the assets can be a very wise and prosperous investment
option. It is almost akin to being on a “hot streak” at the local casino in which a gambler is using the “house’s
money” (or the winnings earned from the casino) in order to try to create even higher winnings with the
gambler’s compounded parlays or bets.
For example, the $100,000 home that a homeowner purchased in 2012 using just $5,000 down (excluding
closing costs or potential seller credits) may now be worth $125,000 in 2013. As a result, the property owner
generated a potential $25,000 gain in appreciated value off of just a $5,000 cash down investment (excluding
monthly mortgage payments, of course).
However, leverage can be a very bad thing if that same $100,000 property listed above now sells for $80,000. If
true, then that same $5,000 cash down payment investment is now worth a whopping negative $20,000 ($20,000), excluding closing costs and monthly payment obligations.