Leveraged Investments

Posted On: 2007-01-23Length:

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Hello and welcome to Money Girl's quick and dirty tips for a richer life.

Today's topic is leverage. This is one of my favorite financial topics. And here's why. Leverage can turn an ordinary income and savings into real wealth. It's the key behind the fortunes behind many millionaires. So what is leverage and how can you use it to take control of your financial future? Leverage means using a lever. It's the power to lift something really heavy with a small effort. When it comes to money, it means using borrowed money and a relatively small initial investment to control a much larger asset. So what types of investments allow you to use leverage? Well, real estate is one of them. It's possible to invest in a home using a very high degree of leverage, or OPM, other people's money. This means that over the long term, you get the benefit of appreciation on the value of the house, but most of the money used to buy it is the lender's not yours. This is one of the biggest benefits of investing in real estate. For short-term investors, however, it's also one of the biggest risks.

Although home price appreciation has slowed nationally, over the long term, real estate has appreciated about 5 to 6 percent per year, on average, in the U.S. Now this return may not sound like anything to write home about, but the power of leverage can really magnify it. Let's look at a simple example. Imagine you buy a house for $100,000 and put $20,000 down. That's 5:1 leverage. If the house appreciates 5% in the first year, you've earned $5,000 on your $20,000 investment from the appreciation. That's a 25% return, not accounting for closing costs. It's an impressive return. If you put only $10,000 down, that is if you use 10:1 leverage instead, your return from the appreciation doubles to 50%. Now that's an amazing return. This example is very simple to illustrate the point. It doesn't account for net rental income if the house were rented. Assuming the house were rented and generated a positive cash flow, the returns would be even better. Simply put, leverage can create millionaire returns. With leverage you can create wealth much more quickly than you could if you paid all cash for a property. If you bought the same $100,000 house for all cash, your return, based solely on that 5% appreciation would be, of course, 5%. By putting 10% down instead, the return is boosted 10 times to 50%. In the U.S. it's not unusual to put as little as 10% down, with the lender financing the remaining 90%, even on a house purchased as an investment.

With stocks the highest leverage you can get is typically 50%. Which means you can buy stocks at half their price with the brokerage house supplying the rest of the funds. Using borrowed money to purchase stocks is called buying on margin, but you've got to be really careful. It can be very risky. With stocks, you can get a margin call. If the stock falls below a...