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What is leverage?
Leverage, or financial leverage, is debt incurred by a company to invest in more assets in the hope of getting a better reward. When you borrow money, you only need to pay interest on it, and now you have leverage to purchase an asset that was previously out of reach. You stand to make a profit on that asset if its value exceeds your interest on the loan.
Normally, a company has assets, and it sells them for a profit. Those assets are considered unleveraged.
Leverage is risk a company takes on because it expects that adding or expanding its assets will produce value in the future. If it takes out a loan for $100 with 2 percent interest, it could then use that $100 to buy a new asset. If after a year of developing that asset it’s now worth $400, the borrower pays back the principal plus interest of $102 and keeps a profit of $298.
However, if the asset depreciates in value or fails to turn a profit, you’re on the hook for the money. If that $100 investment turns out to be worth $80, you lose $22 after paying back the loan plus interest.
The amount of debt a company carries in relation to its assets is called its debt-to-equity ratio, which is the sum of all its debt, including what it owes on any leases, divided by its equity. Lending agreements often stipulate limits on what the company can borrow in the form of a maximum debt-to-equity ratio.
One of the most common types of leverage stems from a mortgage. Although you owe money to the bank on your mortgage, you also have a down payment, which functions as leverage. Because the bank’s only stake is the money you owe on the mortgage, you’ll make a substantial profit on a sale if the value of the home appreciates beyond your obligations.
Calculate what your mortgage will be worth using Bankrate’s set of tools.
Amelia sells cookies from a little storefront. Her ability to bake more and expand her business is constrained by her revenue. She asks her bank for a loan, getting a huge boost. She uses the leverage to buy a bigger oven and more baking supplies. Suddenly, she can bake four times as many cookies and quadruples her profits. By the time she has to pay off that loan, her profits have far exceeded what she owes the bank.