For anything to happen, there must be effort. Yet effort alone is not enough. In the end, it is the result that counts. Leverage is anything that causes a small effort to produce a big result. The degree to which the effort is magnified equals the amount of leverage.
There are many different kinds of leverage. It is a powerful tool that takes a wide variety of forms. Like any tool, leverage itself is neither good nor bad. Though it can be very beneficial when used properly, it can also be very harmful. Leverage magnifies the results of the endeavors in which it is applied.
Financial leverage
Unless you’re a physicist or engineer, the thing that probably first comes to mind when you think of leverage, is financial leverage. Financial leverage primarily involves the use of “other people’s money” to make your own efforts more effective. It is an excellent illustration of the power and the pitfalls that leverage can bring to bear.
Let’s look at an example.
Suppose you have $100,000 to invest. You decide that real estate is a good, long-term investment for you. So you buy a rental house in a nice neighborhood. You have no trouble renting this house for $1,000 a month after expenses. This brings you a cash income of $12,000 per year on your $100,000 investment. Plus, the value of the house increases by about $5,000 every year. So far, so good. Your $100,000 investment effectively returns $15,000 per year.
Now, what if you took advantage of a little bit of financial leverage? Let’s say you only pay $20,000 cash for the house, and borrow the rest of the money. Each month, you must pay $750 to pay off the loan, so you net only $250 per month, for a total of $3,000 per year. The value of the house still increases by $5,000 a year, so you have a total return of $8,000 per year. It’s less than if you paid for the whole house in cash, but wait a minute. You paid a WHOLE LOT LESS to begin with.
In fact, you have enough left over to buy four more rent houses in the same neighborhood. Assuming that each one had the same price, loan structure and rent, your total return on investment for all 5 houses would be a whopping $40,000 per year.
So the same $100,000 investment that returned $15,000 without leverage can return $40,000 with leverage.
This all sounds great, but let’s look at the downside. What if the largest employer in town, where you happen to work, suddenly and unexpectedly goes out of business? You’re out of a job, but it is not as bad as it could be, because you still have that rental income. Or do you? Unfortunately, the plant closing has a ripple effect throughout the local economy, and your town slides into a recession. Rental rates drop drastically, to about $650 a month. And house prices decline about 5% per year.
With your five leveraged rental houses you go into what’s known as “negative cash flow.” You can only get $650 a month rent for each house, but you still have to pay $750 a month on the loan. So you must come up with the extra $100 per house, or $500 a month total. Ouch! With no job, that gets kind of difficult. And you’re reluctant to sell the houses because they have dropped in value.
In the event of such an economic downturn, you would have been better off if you had paid cash for one house. You still would be receiving $650 per month in cash. Though the value of your investment would drop, you could more likely afford to “wait the market out” until the recession ends and you’re able to recover what you put into your investment.
Since leverage works both ways, it is important to make provision, create a plan B, should it work against you, you'll be most capable to handle it.
There are many different kinds of leverage. It is a powerful tool that takes a wide variety of forms. Like any tool, leverage itself is neither good nor bad. Though it can be very beneficial when used properly, it can also be very harmful. Leverage magnifies the results of the endeavors in which it is applied.
Financial leverage
Unless you’re a physicist or engineer, the thing that probably first comes to mind when you think of leverage, is financial leverage. Financial leverage primarily involves the use of “other people’s money” to make your own efforts more effective. It is an excellent illustration of the power and the pitfalls that leverage can bring to bear.
Let’s look at an example.
Suppose you have $100,000 to invest. You decide that real estate is a good, long-term investment for you. So you buy a rental house in a nice neighborhood. You have no trouble renting this house for $1,000 a month after expenses. This brings you a cash income of $12,000 per year on your $100,000 investment. Plus, the value of the house increases by about $5,000 every year. So far, so good. Your $100,000 investment effectively returns $15,000 per year.
Now, what if you took advantage of a little bit of financial leverage? Let’s say you only pay $20,000 cash for the house, and borrow the rest of the money. Each month, you must pay $750 to pay off the loan, so you net only $250 per month, for a total of $3,000 per year. The value of the house still increases by $5,000 a year, so you have a total return of $8,000 per year. It’s less than if you paid for the whole house in cash, but wait a minute. You paid a WHOLE LOT LESS to begin with.
In fact, you have enough left over to buy four more rent houses in the same neighborhood. Assuming that each one had the same price, loan structure and rent, your total return on investment for all 5 houses would be a whopping $40,000 per year.
So the same $100,000 investment that returned $15,000 without leverage can return $40,000 with leverage.
This all sounds great, but let’s look at the downside. What if the largest employer in town, where you happen to work, suddenly and unexpectedly goes out of business? You’re out of a job, but it is not as bad as it could be, because you still have that rental income. Or do you? Unfortunately, the plant closing has a ripple effect throughout the local economy, and your town slides into a recession. Rental rates drop drastically, to about $650 a month. And house prices decline about 5% per year.
With your five leveraged rental houses you go into what’s known as “negative cash flow.” You can only get $650 a month rent for each house, but you still have to pay $750 a month on the loan. So you must come up with the extra $100 per house, or $500 a month total. Ouch! With no job, that gets kind of difficult. And you’re reluctant to sell the houses because they have dropped in value.
In the event of such an economic downturn, you would have been better off if you had paid cash for one house. You still would be receiving $650 per month in cash. Though the value of your investment would drop, you could more likely afford to “wait the market out” until the recession ends and you’re able to recover what you put into your investment.
Since leverage works both ways, it is important to make provision, create a plan B, should it work against you, you'll be most capable to handle it.
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