Using a Little Stick to Move a Big Rock.
This is the description of leverage most common in Physics classes. Then you have the diagram: a person using a stick with a little rock underneath it to move a big rock on the other end.
The physical principle of leverage is very simple. A smaller weight over a long distance, when applied to the long end of a lever, can move a larger weight a small distance. Hence, a small man can move a rock larger than himself through the use of a lever.
The Principle of Financial Leverage
Financial leverage is similar to the physical concept. But instead of using a smaller weight to move a larger weight, a smaller equity investment is used, in combination with debt, to purchase a much larger investment. Leverage has the effect of multiplying the return on investment, whether positive or negative. With a smaller initial equity (cash) investment control is gained over a larger investment and the returns on that larger investment are reaped.
Let's look at an example. The first model is the purchase of a $100,000 investment with $20,000 of equity and by borrowing $80,000. The second model is the purchase of a $100,000 with $10,000 of equity and by borrowing $90,000. You will see two scenarios, one with 10% gain, the second with a 20% gain on the investment.
| Equity Investment | Debt | Total Investment | % Equity | New Investment Value | Percent Gain | Dollar Gain | Return on Equity |
| $ 20,000 | $ 80,000 | $ 100,000 | 20% | $ 110,000 | 10% | $ 10,000 | 50% |
| $ 10,000 | $ 90,000 | $ 100,000 | 10% | $ 110,000 | 10% | $ 10,000 | 100% |
| $ 20,000 | $ 80,000 | $ 100,000 | 20% | $ 120,000 | 20% | $ 20,000 | 100% |
| $ 10,000 | $ 90,000 | $ 100,000 | 10% | $ 120,000 | 20% | $ 20,000 | 200% |
As you can see from the table, a return of 10% generates a 50% return on equity with a 20% investment. A return of 10% generates a 100% return on equity with a 10% investment. Debt always comes at the cost of interest. When the interest cost is less than the total return, a greater return on equity should be realized through the use of leverage over not having used leverage.
Leverage has a similar multiplication effect when an investment has a negative return. This means that you can lose more than your initial investment if the negative return is significant. Hence, leverage should be used cautiously and prudently. T
his can mean reap huge rewards for a real estate investor. Imagine an investor with $100,000 of capital for investment in addition to their Sominex Account. With this capital as a 20% down payment they can purchase roughly $500,000 of investment property. Assume the property appreciates at a (moderate) rate of 8% per year for three years. At the end of the three years the equity in the property has increased over $120,000, a return on equity of 120%. When was the last time your IRA performed so well?
Now with close to $220,000 (initial $100,000 + $120,000) in equity the investor can gain control of $1,000,000 in investment property. If the $1,000,000 in investment property appreciates at the same 8% rate, the equity will grow by $80,000 per year.
Hopefully, you can see that real estate leverage can significantly increase return on equity. It needs to be used wisely and in accordance with a well developed plan. Using debt foolishly is called speculation and is the fast-track to foreclosure and ruin.
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