Saturday, February 18, 2006

Financial Leverage

Leverage: Fear and Enjoy!

Leverage: in the investment world, that's the ability to buy something with part equity (ie your cash), plus some portion financed. The portion or ratio financed is the leverage.

I recently read that seven out of ten millionaires achieved that status primarily through real estate. And the reason they were able to do so, was through the wise use of bank-provided (or equivalent) financing. Real estate is often loaned upon on a 3:1 basis of debt to equity. Very few other investments can be financed to this high a ratio.

However, leverage is also to be feared, since it can magnify investment losses. So if you choose to re-finance your home to invest it in the stock market, you have to be careful - careful both that your investment is conservative enough that your principal is protected over the longer term, but also careful that it's likely to grow in value (thus paying for the leverage).

Finally, you also have to have enough earning power - either through your own job OR through the investment itself, that you can afford the increased loan payments.

Leverage - a fabulous wealth creator - or a potential bankruptcy helper!

I'll be discussing leverage - and some different types of leverage - more in the future.


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