In this article:
- How Financial Leverage Works
- Examples of Financial Leverage
- Pros and Cons of Using Leverage
We've all heard the saying, "You've got to spend money to make money." In finance, leverage is when you borrow money to make an investment that will hopefully lead to greater returns. No investment is ever a 100% guarantee—there's always risk. Financial leverage leans into the idea that borrowing cash to cover a new investment has the potential to pay off in the long run.
Let's look more closely at how financial leverage works, along with its potential benefits and drawbacks.
How Financial Leverage Works
What is leverage? It has to do with maximizing your advantage. Leverage in personal investing involves using borrowed funds to buy into an investment. It's widely used in the corporate world as well. Lots of companies, especially startups, continually seek leverage in the form of investor capital they can use to grow their businesses and meet important milestones.
Individual consumers use financial leverage in a different way. Here the focus is on building personal wealth. If you're an entrepreneur or business investor, that might involve putting money into growing businesses. Otherwise, financial leverage covers any personal investment that's made with borrowed funds.
Examples of Financial Leverage
Borrowing Money to Buy an Investment Property
Buying an investment property is a prime example of financial leverage. That may be a rental property that you maintain and lease out to tenants, which can create a steady flow of passive income each month. Alternatively, you may fix and flip properties. In this case, the goal is to turn a profit after buying a property, sprucing it up and putting it back on the market.
Both options require upfront capital. In addition to making the purchase, rental properties require ongoing maintenance and repairs. There are also property taxes, homeowners insurance and other recurring expenses.
Flipping homes has its own financial demands. You'll need funding to complete the purchase and all the necessary repairs and upgrades, which will determine your asking price when you're ready to sell. Unless you've got cash on hand to cover the purchase, you'll have to take out a loan to buy an investment property. It's typically more complicated than buying a primary residence, and may require a larger down payment (usually 20% to 30%). Interest rates and credit score requirements are usually higher too.
Taking Out a Mortgage to Buy a New Home
Everyday folks who take out a mortgage to buy a new home are also flexing their financial leverage. That's because the money you borrow through your home loan is being used to purchase an asset, which is part of your financial portfolio. Every monthly payment you make reduces your loan balance and increases your home equity. This is the amount of your home's value you actually own. The more equity you have, the more money you'll pocket when it comes time to sell.
You can also use home equity to unlock financing. This includes a home equity loan or line of credit, as well as a cash-out refinance. Each option allows you to trade equity for upfront cash. You might use it to cover home renovations, college costs, debt repayment or other major life expenses.
Getting Student Loans for College
Taking out student loans is an investment you're making in yourself. The goal is to use these funds to pay for a college degree that leads to a higher-earning career path. Student loans come in two main forms: federal and private. Federal loans are backed by the government and offer unique borrower protections, like loan forgiveness and income-driven repayment options. Private loans, on the other hand, are provided through private lenders like banks.
When preparing to take out student loans, estimate your expenses. Then research the job market and salary trajectory for your chosen field. This can help you better understand if the financial investment is worth it. If so, you can look into scholarships, grants and tuition assistance programs to make it more affordable.
Borrowing Money to Start a Business
Every startup needs money to get off the ground and eventually become profitable. If self-funding isn't an option, business owners can explore the following sources of capital:
- Business loans
- Business lines of credit
- Business credit cards
- Investments from friends and family
- Venture capital funds, which invest heavily in startups
- Angel investors (wealthy individuals who typically invest in exchange for equity)
- Private equity funds
- Peer-to-peer lending
Business credit may be required when applying for loans, lines of credit and business credit cards. Repaying them as promised can help your business build credit, but falling behind can drag down its score. That can impact your ability to get approved for financing for your business in the future. When seeking this type of business funding, be sure not to bite off more than you can chew.
Tapping Borrowed Funds to Invest in the Stock Market
Most folks use cash savings or disposable income to invest in the stock market. This includes automatic payroll deductions to fund a 401(k), or money you funnel into a regular brokerage account each month. In some cases, you may choose to borrow money to make a larger investment. Mutual funds, for example, typically require a larger buy-in. Minimum investments usually range from $500 to $3,000. Borrowing a lump sum can help you build your investment portfolio faster.
Pros and Cons of Using Leverage
Pros
- Borrowing allows you to invest sooner rather than later.
- Investing now can help grow your wealth over the long term.
- Your investment has the potential to improve your quality of life, such as buying a home you love or starting a meaningful business.
Cons
- Investment returns aren't guaranteed—if things go south, you'll still need to repay borrowed funds.
- Borrowing money from friends and family can put a strain on the relationship.
- If you borrow against your home, you run the risk of losing your home if you default.
- Falling behind on credit card or loan payments can damage your credit.
The Final Word
Financial leverage can help you grow your wealth faster. If all goes well, you'll repay your borrowed funds quickly and snag investment returns in the process. Risk comes with the territory—it's never guaranteed that your investment will lead to financial gains. Regardless, you'll still be responsible for paying back whatever you borrow.
If you're seeking a loan or line of credit, your credit score is critical. The stronger your score, the more likely you'll be to get approved with the best rates and terms. That's why Experian allows you to check your credit score and credit report for free.
