What Is Leverage?
Leverage is nothing more or less than using borrowed money to invest.
Leverage can be used to help finance anything from home purchases to stock market speculation.
Businesses widely use leverage to fund their growth, families apply leverage—in the form of mortgage debt—to purchase homes, and financial professionals use leverage to boost their investing strategies.
What Are the Different Kinds of Leverage?
Leverage has slightly different meanings in personal finance, investing, and business. But in each case, leverage is the use of debt to help achieve a financial or business goal.
Leverage in Investing
Leverage can offer investors a powerful tool to increase their returns, although using leverage in investing comes with some big risks, too. Leverage in investing is called buying on margin, and it’s an investing technique that should be used with caution, particularly for inexperienced investors, due to its great potential for losses.
Buying on Margin
Buying on margin is the use of borrowed money to purchase securities. Buying on margin generally takes place in a margin account, which is one of the main types of investment accounts.
In a margin account, you can borrow money to make larger investments with less of your own money.
The securities you purchase and any cash in the account serve as collateral on the loan, and the broker charges you interest. Buying on margin amplifies your potential gains as well as possible losses.
If you buy on margin and your investment performs badly, the value of the securities you’ve purchased can decline, but you still owe your margin debt—plus interest.
In general, you can borrow up to 50% of the purchase price of margin investments. That means you can effectively double your purchasing power.
If the value of your shares falls, your broker may make a margin call and require you to deposit more money or securities into your account to meet its minimum equity requirement. It also may sell shares in your margin account to bring your account back into good standing without notifying you.
Leveraged Exchange-Traded Funds (ETFs)
You can use leverage in investing outside of a margin account as well. Leveraged exchange-traded funds (ETFs) use borrowed funds to try and double or even triple gains in their benchmark indexes
That means if an index rose 1% on a particular day, you might gain 2% or 3%. Of course, the opposite is also true. With leveraged ETFs, a 1% decline suddenly magnifies to 2% to 3%.
It’s important to note that on most days, major indexes, like the S&P 500, move less than 1% in either direction, meaning you generally won’t see huge gains or losses with this kind of fund.
Leveraged ETFs are self-contained, meaning the borrowing and interest charges occur within the fund, so you don’t have to worry about margin calls or losing more than your principal investment.
This makes leveraged ETFs a lower-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 they often carry much higher expense ratios than index funds simply seeking to track market performance.
Financial Leverage in Professional Trading
Professional investors and traders take on higher levels of leverage to more efficiently use the money they have to invest.
Using leverage gives professionals more flexibility in directing the money they have to invest.
With leverage, they can drastically increase their purchasing power (and associated returns) and potentially invest in more companies at one time using smaller amounts of cash and larger amounts of debt.
Traders also aren’t limited to the same requirements as average investors. \For example, depending on the Forex broker a trader uses, they could request orders of 500 times the size of their deposit. That discrepancy between cash and margin can potentially increase losses by huge orders of magnitude, leaving it a strategy best left to very experienced traders.
The Bottom Line
Borrowing money allows businesses and individuals to make investments that otherwise might be out of reach or the funds they already have more efficiently.
For individuals, leverage can be the only way you can realistically purchase certain big-ticket items, like a home or a college education.
While leverage affords plenty of potential for upside, it can also end up costing you drastically more than you borrow, especially if you aren’t able to keep up with interest payments.
This is particularly true if you invest funds that aren’t your own. Until you have experience—and can afford to lose money—leverage, at least when it comes to investing, should be reserved for seasoned pros.