Financial Education: Leverage Part 1

You may know or heard about leverage, but do you actually know how they work?

I’ve come across many pundits, books, and articles that showed how leverage can make you fortunes. What many of them didn’t mention was that it could BREAK your piggy bank if things turn sour. You can think of any failed institutions over the past year and you will see the use of over leverage was one of the main reasons they failed. This is true for when they were prosperous and was profiting hand-over-fist during the uptime from the use of leverage. So let’s drill down to what and why we use leverage.

Before going into how they work and why we use them, let’s walk through some quick basics and definitions.

According to Webster definitions, leverage is the use of credit to enhance one's speculative capacity. Investopedia has more description but I won’t go into it but if you want to know, refer to this link.

To put it in plain English, leverage is the use of other people money (borrowed money or margin) to enhance your gain or LOSS. I capitalized LOSS for a reason because if you fail to understand the concept of leverage, chances are your piggy bank will be broken.

Now let’s go into why and how you can use leverage. As stated before, you use leverage to enhance your profit and loss. Quick and simple. The how is a little big complicated but I’ll simplify. Many Americans leverage their asset(s) without knowing. That asset is a purchase of home. The basic concept here is you use the bank money (mortgage) to help control large asset such as home.


Example:

Home Price: $100,000
Down Payment (Equity): $10,000 (10%)
Mortgage (Debt): $90,000 (90%)


Now, let’s assume that your home price rose 10%, you’ll then get
Home Price Rose to: $110,000
Debt: $90,000
Equity: $20,000

So from this scenario, you just made 50% Return on Equity (ROE, your equity rose to $20,000 from $10,000) that is if you sell. If you never sell, you never profit.

Now, let’s assume that your home price fell 10%, you’ll then get

Home Price Fell to: $90,000

Debt: $90,000

Equity: $0

So from this scenario, you just loss all your money!!!

This is what happened during the housing boom. Many retail investors started “speculating” out of greed and went to places like Countrywide to get a no-doc loan. Some of the buyers didn’t even have money down so if you do the math, it is rather scary. Imagine purchasing a California home which I can say to be around $600,000 with no money down. When market turned… their piggy bank weren’t just broken, it was crashed again and again.

The situation is very complicated and led to the failure of many institutions such as Bear Stearns, Lehman Brothers, Countrywide Financials, Freddy Mac, Fanny Mae, Indy Mac.

My point is, if someone like Robert Kiyosaki (author of Rich Dad, Poor Dad) or David Bach (author of The Automatic Millionaire) urges you to use leverage, know that risk is high. Mr. Kiyosaki sited that he likes to use the bank money to leverage. As you see from the example above that leverage can be both good and bad. Always keep in mind that risk = reward.

In my next write up, I will walk you through the best methods of using leverage that is relatively safe and could enhance your wealthy tremendously.

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