What is Leverage Investment

Darryl Bachmeier
Aug 26, 2020

If you are a student of accounting and financing, then you may have heard the term leverage and leverage investment. What do they mean? What benefits they may offer and what shortcomings do they have? Are there any variations of leverage investment? Let’s find out.

What is leverage investment?

Leverage is a common investment strategy in which someone uses debt in place of assets or equity to finance a project/ investment. In simplified language, you as an investor need money to fund a project. You borrowed money and used that borrowed money for funding the project rather than using your own money. This act of using borrowed money on an investment is called leverage investment.

Why do investors use leverage investment?

Leverage investment is associated with debt. No one likes to keep debts on their shoulders. Then why do investors use leverage investments instead of their own assets/ equity on an investment? There could be many reasons. If you think about those reasons, leverage investment isn’t that bad of an option.

A quick source of finance

The obvious reason is that the investor might be short on money for financing the project. In that case, leverage investment is the best option. Because the investor decided to wait for a few months to save money by themselves for the project, it may not work. In today’s world, time is money. Finance students are very familiar with the concept of the time value of money. The concept suggests that as time passes, money loses its value. What’s worth $1000 today can be worth $600 in the next year, depending on the many external variables, the value can go down more than $600. So, if you wait for a few months, your investment can go down by a million dollars. So, the best option is to use leverage as an investment.

Increase value of investment

Suppose your investment is worth $10 million. If you have the option of adding $5 million more using leverage investment, wouldn’t it be better? Obviously. Your investment will increase in value. More value means more return. You will be able to easily pay back the leverage you borrowed within a few months if everything goes as planned.

Liabilities are paid first

One plus side of leverage investment is that it counts as a liability. Accounting students know exactly what that means. Liabilities are paid out first then owners’ equity. So, if your investment was financed using leverage money, it will be paid out first and there is a very low risk of your company going into long-term debts. Types of leverage investment Although we gave examples of leverage above using a company’s investment, there are three types of leverage investment. Each of them is slightly different from the other in terms of their functionality.

Leverage in business

Some perfect examples of leverage in business could be the issuing of stocks or bonds. In either of these two, the business doesn’t have to completely give up its ownership. In stock issuing, the business raises money by selling part of their ownership, making each moneylender part of their company as a stockholder. Bonds are more like debts but they often have easy terms for the business to pay back the money. Leverage investment is very useful for small businesses and startups. They can utilize the lent money and expand their company to establish itself as a self-sustaining firm.

Leverage in investing

Also known as Buying on Margin. Leverage in investing, as mentioned above, has many benefits. The investor can increase the value of their investment and get double the return. They can quickly fund a project and get it running. Leverage in investing is associated with debt, hence it is recorded in margin accounts. As it is borrowed money, you will have to pay back some interest to the lender. Margin account calculates this interest over time and shows results of your potential gain and also losses. Leverage in investing may seem like an easy option. But it can be very risky. You should consider many factors before using leverage in investing.

Leverage for personal finance

Leverage in personal life is something we use almost every day. We may not know it but it’s true. Imagine borrowing $5 from your friend just for a day. It may seem like a friendly gesture but it is a leveraged investment. You borrowed $5 from your friend for what? just to keep it? No. You may have borrowed it to finance your transportation cost for returning home or buying a cup of coffee. This is a small example. Let’s look at some big ones. Buying a house, buying a car, taking student loans. These all have something to do with leverage. When you buy a house on a mortgage, you are borrowing money for that moment to buy that house. Over time you pay that mortgage to pay back your loan. If you are buying a car on loan, it also counts as leverage. So does student loans. In student loans, you are borrowing money for financing your education, which you will return in the future.

Things to consider in leverage investment

Leverage may seem like an easy option for financing a project instantly, but it is very risky. To avoid getting yourself tangled in leverage to pay back forever, you should consider several factors. First, you need to look at the interest rate the lender will charge from you. Calculate everything and see if your investment can generate enough return to pay it back. Also, make sure your investment is secure enough to generate returns. And prepare a backup means of paying back the leverage if things go wrong.

Final Verdict

Leverage investment is very useful in times of emergency. But it is very risky. So always evaluate all the factors before making a leverage investment.

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