Since ``leverage'' is so often used as a synonym for debt, let's review how debt leverage works in a common financial transaction--buying a house. Suppose you want to buy a house as an investment, and that the house costs $100,000 (this is a hypothetical example, after all), and you can expect to get about $600 per month in rent from the house. Suppose you were fortunate enough to have the full $100,000 in savings and bought the house for cash. If you sold the house one year later for $110,000, you would have realised a total before-tax gain of $17,200 on your investment, the $10,000 appreciation in the value of the property, plus 12 months of rent at $600 per month. Dividing the proceeds by the investment, you would have realised a yield of 17.2% on your $100,000 capital.
Most people don't have $100,000 in the bank and even if they did, they wouldn't want to tie it up in one investment. Suppose, instead, you bought the house by making a $20,000 down payment and borrowed the balance of the purchase price, $80,000, by taking out a mortgage secured by the house. If mortgage rates were 12%, you'd be making payments of about $800 a month, but since those interest payments are tax-deductible you'd be able to cover them from the rental income. When you sold the house at the end of the year for $110,000, you'd end up with a gain of $10,000 (assuming the rent just covered the loan payments), or a gain of 50% on your investment of $20,000. If you'd had $100,000 with which to play the market, you could have bought five houses this way and wound up the year with a gain of $50,000 compared to the non-leveraged gain of $17,200.
This is debt leverage, and it works the same in real estate, trading stocks on margin, or taking over companies in leveraged buy-outs. If it's so neat, why doesn't everybody do it? Because leverage is a double edged sword. Debt leverage simply magnifies the effect of changes in price compared to your original investment. If the market moves in your favour it works to your benefit; if the market moves against you, your losses are magnified and may total much more than your original investment. In addition, once you assume debt you are committed to making the payments on it--if you miss a payment you can lose everything, so you must be very confident of a continuing flow of cash to service the debt.
These aspects of debt leverage have given it a well-deserved bad name. So many economic cataclysms, business failures, and personal bankruptcies have resulted from debt leverage that its enthusiasts tend to be the lucky and its defenders those with short memories.
Editor: John Walker