Two Types of Leverage
1) Leveraging relationships – Let’s say that you have assets to invest, but aren’t sure what to invest in. You have a friend who has expertise in a particular field but can’t capitalize on it as much as the potential is there for without more capital. You can each leverage what the other has to bring more value to the market and more income or capital gains to yourselves. Both parties win. Of course, the flip side to this is that if something goes wrong, it could potentially be within the area of expertise of your partner and thus somewhat out of your control. Of course, any venture of scale at all must involve other people, so if you’re looking to steward greater wealth, working well with others becomes an area you must learn to love.
2) Leveraging money – This involves borrowing money on top of what you’ve staked into an investment. Because the loan typically has terms that have nothing to do with the underlying investment, a successful enterprise can pay off the loan while returning a potentially large profit on your original investment. Of course the flip side is that if the investment goes the other way, you still must repay your loan but the asset which you borrowed for has itself lost money.
A few examples of this would be:
A) Buying a rental property and putting a 20% down payment while borrowing 80% from the bank. If the property costs $200,000 this means that you would have put down $40,000 and borrowed $160,000. If at the sale of the property, you sell it for $240,000, you have made a 100% profit on your original down payment. (Versus a mere 20% profit if you would have used all of your own cash.)
But if you had to sell the property at $160,000 because the market had turned, you would lose everything you put into the investment. (Versus losing only 20% if you had used all of your own cash.) Of course, if the market dropped further, you would have to either come to the closing table with cash to pay off your mortgage, or take a serious hit on your credit – one way or another.
B) Buying stock on margin is another example. If you have a margin account set up with your broker, they will lend you money up to the amount that you have invested to buy stock. Again, this works fantastically when the stock goes up, but can cause even more severe pain than the real estate example when the stock market heads south. You will get a margin call at a certain point demanding that you add more cash to the account or else they will sell the stock that you had purchased. So in this case, it could quickly not be an option to even continue holding the asset. Needless to say, this is a very risky strategy for most investors.
C) Another option that is gaining popularity are leveraged ETF’s. Exchange Traded Funds are somewhat like a cross between a mutual fund and a stock. They are traded on an exchange like a stock, but typically comprise more than one security. They are often used by traders to focus on a particular market segment. There are now multiple ETF’s in existence that will seek to achieve 2x, 3x, or even more the return of the index that it is based upon. You should be aware that these work decently well in the short term, but not well in the long term.