One of the best ways to illustrate leverage and your money, is your mortgage.
When we borrow money from a bank, they charge us an interest rate for doing so. When we pay it back, we pay the borrowed amount plus the interest, let’s say 3%.
Now if you use that money to buy something that appreciates in value more than this interest rate, then you make a profit.
During any housing boom, houses tend to go up more than 3% per year. So if they went up by say 6% one year and you paid off your mortgage, you will have made 3% profit on the amount that you borrowed.
Let’s look at a simple example. If the value of your house was 200,000 and your mortgage was 100,000 and the interest rate was 3%. A year later, the value of your house is now 250,000, but you only have to pay back to the bank 100,000 plus 3,000 in interest, a total of 103,000.
So you have made 47,000 by borrowing 100,000 for one year. (=250,000-200,000-3000). This is a 47% return on investment!
The important point is that you have used the bank’s money to make half of this profit. (your investment of 100,000 has made the other half). This method of investing is called using OPM or ‘Other peoples money’ and is one of many powerful investment strategies.
Another example of leveraging money is buying options on stock and shares.
With options, the amount of money you spend to be in the investment is much lower than buying the equivalent amount of shares.
If you bought 100 shares of ABC company at 50 each, that would cost you 5,000.
If they went up to 60 and you then sold them, you would have made 1,000 on a 5,000 investment or 20%. This is quite a good return on investment in any one’s books.
The equivalent option (which controls 100 shares) would cost around 400 and would be worth 800 if you sold it at a share price of 60. Now, you have made 400 profit on a 400 investment and doubled your money.
The disadvantage with leverage and buying options is that if the share price went down, the leverage would work against you and you could lose all of the money you put into the investment. So this is a risky form of leveraging your money.
So there it is, leveraging your money is a powerful idea when used correctly, but it can be dangerous if it works against you.