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What Is 'Leverage'?

Leverage is the practice of using borrowed money to magnify potential gains. If you have an investment that promises to double, you can make 10x if you borrow money and make that investment five times.

Leverage is a form of financial Amplification. It magnifies gains and losses.

Using Leverage is dangerous. Never do it unless you are aware of the financial risks for yourself and your business.

Josh Kaufman Explains 'Leverage'

Using "other peoples' money" sounds like a great way to make a fortune. Borrow some money, make a fortune, pay back your lender, and keep the rest. What could be better?

Making money by borrowing from others can be savvy, provided you're aware of the risks.

Leverage is the practice of using borrowed money to magnify potential gains.

Here's an example: let's assume you have $20,000 you'd like to invest in real estate. You could use that money as a 20% down payment on a $100,000 property, borrowing $80,000, but that ties up your all of money-an example of opportunity cost.

Instead of using the $20,000 for a single down payment, you could take the same money and invest in four $100,000 properties, each with a down payment of $5,000. That strategy requires borrowing $95,000 four times-a total of $380,000 in loans.

Here's where the magic happens.

Let's assume the properties double in value, and you sell them. In the first scenario, you'd make $100,000 on a $20,000 investment-a 5x return on investment. In the second scenario, you'd make $400,000 on the very same $20,000 investment-a 20x return on investment.

No brainer, right?

Not so fast-what would happen if the value of each property drops dramatically, and you sell them to get back as much money as you can?

Assuming the property value drops by 50%, in the first scenario you'd lose $50,000. In the second scenario, the use of leverage magnified your losses to $200,000-four times as much.

Leverage is a form of financial Amplification-it magnifies the potential for both gains and losses. When your investment pays off, leverage helps it pay off more. When your investment tanks, you lose more money than you would otherwise.

One of the major contributing factors of the recession of 2008 / 2009 was the use of enormous amounts of leverage by investment banks. It wasn't uncommon for banks to leverage their investments by a factor of 30-40. Millions (or billions) of dollars were made or lost when the value of a particular stock went up or down by a single percentage point. When the market crashed, the bank's losses were magnified by the amount of leverage they took on, which was more than enough to threaten their existence.

Using Leverage is playing with fire-it can be a useful tool if used properly, but it can also burn you severely. Never use leverage unless you're fully aware of the consequences and are prepared to accept them. Otherwise, you're putting your business and personal financial situation at risk.

Questions About 'Leverage'

• Does leverage make sense for your particular business idea?
• What opportunities and risks does leverage present, given your current situation and goals?

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"We've been criticized for not understanding what the word leverage means... We do know what leverage means, and having a few million dollars cash in the bank is much nicer than being heavily leveraged."

Kenneth H. Olsen, founder of the Digital Equipment Corporation (DEC), which was acquired by Compaq in 1998

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