What is Leverage?
In finance, leverage refers to the use of borrowed funds to purchase an asset, with the aim that its price appreciation and/or income it generates after taxes from the asset will exceed the borrowing cost.
Leveraging is a process that enables gains and losses to be spectacularly amplified. The opposite of leveraging is deleveraging.
The most common case of leverage is when an individual leverages their savings when buying a property, say a house, by borrowing a portion of the cost with a mortgage.
The same leverage situation occurs in stockmarkets when someone borrows money from their broker in order to buy a financial asset.
An example would be if someone only has £20 in cash to invest in an asset. If the operation goes well and they get £40 back, the profit has been 100%. But if they had borrowed £80 extra, the profit would be £120. In other words, a 600% profit – thus leveraging the investment gains.
The risks of leveraging
The downside of this practice comes when the situation goes wrong, and the investor loses not only their cash, but are now also weighed down with debt. Because of this, leverage providers limit how much risk they take by limiting how much they will lend overall. They also include clauses in their leverage agreements like obligations to provide assets as collateral before they issuing loans.
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Category: Financial Glossary