What is leverage?
Leverage is borrowing money to buy assets while expecting a rate of return exceeding the interest rate together with the borrowed money.
How does it work?
Let’s take for example in a normal deal John who has $10,000 in cash buys a car for $10,000. He then sells it to Tim for $11,000 and makes a $1,000 profit. This is a good as john just got a rate of return of 10%.
Now by using leverage John with his $10,000 borrows $990,000. With $1,000,000 in hand, he buys 100 cars. Sells them for a $1,100,000. After he pays back his $990,000 plus $10,000 in interest which will give him an awesome profit of $90,000. Bringing him a rate of return of 900%.
Leverage can be used in the real estate market , stock market and bond market.
Risk with leverage
Leverage is considered great for making deals. But it also has it disadvantages. It can turn against the investor. It can magnify gains as well as losses.
Let’s look again at our example from above. John took a debt of $990,000 to buy 100 cars. What if the price of the cars fell to $9000 after a month. He sells the cars for $900,000 at a loss of $100,000. If he bought just a car at $10,000 and sold it at $9000. He would have just lost $1000.
Leverage can be dangerous and must be used with caution. Once you learn how it works and handle it with care. It is usually one of the best way to attain great wealth.