A mechanical lever is a handle or a bar pivoting on a fulcrum. The difference between the bar length on either side can increase (or decrease) our ability to move an object. Economists call the advantage we may gain from borrowing and reinvesting “leverage”, because it can increase our financial muscle too.
A Simple Example of Financial Leverage in Action
Imagine for example we have a windfall and end up with a spare $100,000 to invest. We have our eye on a very nice $500,000 house and convince the bank to lend us the other $400,000. If the real-estate market rises by 5% in the first year of the loan, the house is now worth $525,000. Of course we would have to offset the interest on the loan to establish our true gain.
Perhaps we are more conservative and don’t believe in borrowing money. In that instance, we could purchase a small apartment for cash and remain debt free. If the real-estate market rises by 5% in the first year of the loan, the apartment is now worth another $5,000 and this all theoretically belongs to us.
In the first example we used leverage from a loan to increase our investment, and it worked in this case. However if the market had gone the other way we could have lost five times the amount of money. This principle applies to both real estate investment, and a home we buy to live in.
The Two Most Important Things to Remember with Leverage
Avoid Being Over-Optimistic About Returns
The past is far less likely to repeat itself than we think. Property values fluctuate, and can swing widely as a result of global events. Determine your likely return based on this formula:
( Most Optimistic + Most Pessimistic + [4 x Most Likely] ) Divided by Six
Investments are like babies in diapers. You have to watch them all the time and know the warning signs.
Remember to Treat the Bank’s Money as Your Own
You still have to pay the money back when you leverage a bad investment. Warren Buffet follows two principles. These are “the market can price things wrong” and “a high return with low risk is the key”. Don’t let overconfidence burn a hole in your pocket!
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If you are in Calgary and you have money to invest, then you should definitely visit our fine portfolio of properties for sale. We take the heavy lifting out of market research, so you can concentrate on growing your wealth.