It’s fair to say that leverage is misunderstood; in fact, that’s putting it mildly. I even confess to being possibly too quick to dismiss the whole idea of leverage in the past, because of my own too-narrow understanding of what it really means. In this chapter we’ll explore the concept and look at how you might apply it to further accelerate your own wealth-building success.
Everything You Need to KNOW
1. Leverage is Misunderstood, and Consequently Ignored
What exactly does it mean to apply leverage? If you think back to early physics lessons in school, you’ll remember that a lever and a fulcrum allow larger masses to be moved by smaller effort. Put simply, using a lever amplifies an input force to provide a greater output force.
There’s a famous quote attribute to Archimedes, who said:
“Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”
In personal finance terms, applying leverage usually means borrowing money to put to work in some way – most often by taking out a mortgage to buy a property – but it certainly doesn’t have to mean just that.
In the last chapter, we saw that tax relief and employer match into pensions is a form of leverage – you’re using someone else’s money to move more quickly towards your goals. This kind of leverage doesn’t have to be paid back either, which is one reason it’s so important to maximise the use of these benefits.
2. Financial Leverage Amplifies BOTH Gains and Losses
This is probably the most important concept to understand when considering the use of leverage. Let’s illustrate this with an example. Let’s say you have £10,000 to invest. You could invest that money in the stock market and over time it will grow. You buy £10,000 of shares in a multi-asset fund and given a decent return, you could double your money in ten years.
But let’s say you take your £10,000 and use it as a deposit to buy a £100,000 house. You borrow £90,000 on an interest-only mortgage. The rent from the property pays the mortgage and all other costs and the property doubles in value over the same ten-year period. You now own a £200,000 property with a £90,000 mortgage on it.
Your £10,000 has turned into £110,000 equity in the property. That’s an insane difference, isn’t it? £10,000 becomes £20,000 without leverage or it becomes £110,000 with leverage – very cool. You’ve bought a bigger asset, so it grows proportionally larger and your bit grows bigger too.
So how might that same leverage amplify any potential losses? Well, if your £10,000 fund investment goes down, you’ve only lost your own money, and only when you sell. But if you borrow £90,000 to buy that house, there’s a housing crash and the property suddenly ends up being worth £80,000, then you have a major problem.
Not only have you lost your original £10,000, but you’ve lost £10,000 of someone else’s money too. You don’t have anything now to pay back the debt – you can’t sell the property and you’re still paying interest on the mortgage.
You’re now minus 100% of your initial stake, because the property is now only worth £80,000 and you still owe £90,000. You’ve essentially lost two lots of your original £10,000. Even though the property has last 20% of its value, you’ve lost 200% – twice your original stake. Leverage allows you to buy more or bigger assets, on which the growth potential is correspondingly larger, but so is the loss potential, and we can’t minimise that.
Let’s go big. You borrow £1,000,000 and invest it into the stock market. Your money doubles over twenty years this time, and you use the dividends payable by your investments to pay down the loan over that period. You now have £2 million of shares and no loan. You used someone else’s money to build a £2 million portfolio.
But if your investments fold, you’re not back to zero – you’re MINUS £1 million owed to your lender. In order to make best use of leverage, you need to invest wisely using the money you borrow, and you need to manage the downside risk.
Ready to move on? Or are you looking for the end of the last blog series?
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