Leveraging is nothing more or less than using borrowed money to invest. Leverage can be used to help with anything from home buying to stock market speculation. Businesses use leverage to finance their growth, households use debt to buy homes, and financial professionals use leverage to enhance their investment strategies.
What are the different types of use?
Leverage has a slightly different meaning in personal finance, investing, and business. But leverage in each case is the use of debt to achieve a financial or business goal. There are four main types of consumption:
1. Invest in business
Businesses use leverage to launch new projects, finance inventory purchases, and expand their operations.
For many businesses, borrowing money can be more beneficial than using equity or selling transactions for cash. When a business uses a business – by issuing a bond or taking a loan – there is no need to give up the ownership stake in the company, when a company takes on new investors or issues additional shares.
Leverage can be useful for small businesses and startups that may not have a lot of capital or assets. Using small business loans or business credit cards, you can finance business operations and get your company off the ground until you start making a profit. When you take out a loan or line of credit, interest payments are tax-deductible, making it even more beneficial to take advantage.
When evaluating businesses, investors consider the company’s financial strength and operating performance.
Financial leverage refers to how much debt a company has in relation to the amount of money its shareholders have invested in it, also known as equity. This is an important figure because it indicates whether a company can pay off all of its debt with the money it has raised. A company with a high debt-to-equity ratio is considered a riskier investment than a company with a low debt-to-equity ratio.
Operating leverage, on the other hand, does not consider borrowed funds. Rather, it is the ratio of a company’s fixed costs to its variable costs. Companies with high fixed costs, such as manufacturing firms, have high operating leverage. High operating leverage indicates that if a company is in trouble, it will be more difficult to make a profit because the company’s fixed costs are relatively high.
2. Use in personal finance
When it comes to your personal finances, you might be surprised how often you are used to it. When you borrow money to acquire wealth or leverage your money, you are using leverage. You can use incentives when you do the following.
Buy a house. When you buy a home with a mortgage, you are using equity to buy a property. Over time, you build equity—or ownership—as you pay off more and more of the mortgage. This is how you get a return on your investment in your home.
take out Student loans: When you borrow money for school, you are using your debt to invest in your education and future. Over time, your degree will increase your earning potential. Higher wages allow you to recoup your initial debt-backed investment.
Buy a car: If you want to buy a car, you can buy it with a car loan, a method of use 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 get a good ROI, and car ownership can be necessary to generate income.
Make sure you weigh the pros and cons before using it in your personal life. Going into debt can have serious consequences if you can’t pay back what you owe, such as damaging your credit or leading to foreclosure.
Leverage can provide investors with a powerful tool to increase returns, although leveraging leverage comes with some significant risks. The advantage of investing is called buying on margin, and it is an investment technique that should be used with caution, especially for inexperienced investors, as it can lead to significant losses.
Buying on margin
Buying on margin is using borrowed money to buy securities. Buying on margin is generally done in a margin account, which is one of the main types of investment accounts.
With a margin account, you can borrow money to make larger investments with less of your own money. The securities you buy and any money in the account serve as collateral on the loan, and the broker charges you interest. Margin buying highlights your potential gains and potential losses. If you buy on margin and your investment goes bad, the value of the securities you bought may go down, but you still owe your profits — and interest.
Generally, you can borrow up to 50% of the purchase price of margin investments. This means you can effectively double your purchasing power.
If the price of your shares falls, your broker may make a margin call and require you to deposit additional funds or collateral into your account to meet the minimum equity requirement. It may also sell shares in your margin account to restore your account to good standing without notifying you.
Leveraged Exchange Traded Funds (ETFs)
You can use leverage to invest outside a margin account. Leveraged exchange-traded funds (ETFs) use borrowed funds to try to double or triple their earnings in benchmark indexes.
This means that if an index rises 1% in a particular day, you can earn 2% or 3%. Of course, the opposite is also true. With leveraged ETFs, a 1% discount suddenly grows to 2% to 3%. On most days, major indices like the Nifty50 move less than 1% in either direction, which means that you generally won’t see big gains and losses with this fund.
Leveraged ETFs are self-sustaining, meaning that loan and interest payments happen within the fund, so you don’t have to worry about margin calls or losing more than your original investment. This makes leveraged ETFs a low-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 often carry higher expense ratios than index funds that seek to track market performance.
Investing using loans
While the benefits of personal investing mean 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 the investment minimums of some brokerages or mutual funds, you can use this approach to build a portfolio right away. (That said, many brokers and robo-advisors now allow you to buy fractional funds, lowering the minimum investment amount to INR 500 or even INR 100.
Some of the most common debt-based investment strategies include:
Take out a home equity loan: Some people tap into their home equity and take out a home equity loan or home equity loan (HELOC) to finance their investment. With this approach, you can get cash to invest as you wish. But this is a risky approach, because not only do you lose money if your investment falls, but you put your home at risk 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 for investing. Personal loans are usually unsecured, so you don’t have to use property as collateral. But they charge interest and have relatively short repayment terms, which means your investment should earn at least enough to offset the interest you can quickly accumulate.
Use Credit Card Cash: If you have a low-interest credit card, you can take out a cash advance and invest the money. However, cash advances often have a higher APR than purchases and often have upfront fees. With a higher APR, you need to earn more to make this approach worthwhile.
4. Financial capacity of professional trading
Professional investors and traders take a high level of efficiency in using their money to invest.
Leveraging leverage gives professionals more flexibility in managing the money they need to invest. With leverage, they can significantly increase their purchasing power (and associated returns) and invest in multiple companies at once using a small amount of cash and a large amount of debt.
Traders are not limited to the same requirements as average investors. For example, depending on the forex broker a trader uses, they may require an order of 500 times the deposit amount. That difference between cash and margin can add up to losses on large orders, a strategy best left to more experienced traders.
Borrowing money allows businesses and individuals to make investments that would otherwise be out of reach or to make more efficient use of existing funds. For individuals, you may find the only way to afford some big-ticket items like home or college tuition.
While leverage has a lot of potential, it can end up costing you more than you borrowed, especially if you can’t keep up with the interest payments.
This is especially true if you invest money that is not your own. As long as you have experience – and as long as you can afford to lose money – it should be used, at least when it comes to investing, only for an experienced professional.