The word "leverage" gets used in business and finance with an aura of a magic word for achieving success. But leverage, in its simplest form, is actually something very simple: working with borrowed funds- most likely cash- to achieve more. If you are a student who is investing, a small business owner forming a company, or even a homeowner as a buyer of a family home, leverage can be your ticket to accomplishing more than you are able on your own with your own resources. Let's break it down into simple parts so we can see how leverage works, why it works so well, and how to use it well.
What Is Leverage?
Leverage is taking a ladder from someone so you can reach higher than you can alone. Financial leverage is the use of borrowed money to invest in some asset- a house, a business, or stocks- in the hope that the return will be greater than the cost of the loan. Leverage, for example, is when you buy a $100,000 house with $20,000 cash and an $80,000 bank loan. As the home increases to $120,000, you've made a $20,000 profit on your $20,000- a 100% profit- without paying interest on more than the loan.
Why Is Leverage Important?
Leverage is a technique of stretching your resources, placing large goals within your grasp. For a small business, borrowing $50,000 to buy equipment can grow production and profit faster than saving. For an investor, borrowing to buy stocks can grow gains when the market rises. Leverage is a double-edged sword, however: it multiplies losses the biggest too. If that house falls to $80,000, you've lost your $20,000 and still owe the bank. This risk-to-reward ratio makes leverage a game-saver for anyone who uses it wisely, whether saving for college or building a business.
How Do You Use Leverage?
Leverage starts with borrowing wisely. In individual finance, a mortgage is standard leverage, enabling you to possess a home while you pay it off incrementally. In business, expansion can be funded by lines of credit or loans, like opening a store. Margin accounts with borrowed money from a brokerage to buy more stocks can be used by investors. The key is to borrow as much as you can and invest in something that will appreciate. A low-interest student loan, for instance, can be used by a student to earn a degree, boosting future income to repay the loan. Always match up the interest rate and your payment schedule to avoid getting caught.
Using Leverage Properly
Suppose there's a young entrepreneur with $10,000 to invest in a coffee shop. Instead of leasing a small store, he borrows $40,000 to lease a bigger store in a more active area. If the store generates $20,000 in profit per year, he can pay off the loan quickly and keep the profits. But if the shop goes bust, they're liable for the loan. To leverage successfully, investigate your investment, keep debt levels in check, and have a backup plan. Whether you're buying a rental property or borrowing to start up, leverage can make small moves result in giant leaps if you marry ambition with caution.
Leverage is not just for Wall Street—it's a practical strategy for anyone looking to grow their wealth or business. By borrowing wisely and being aware of the risks, you can leverage this to reach your goals faster, making an abstract concept an active catalyst for success.
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