Tuesday, May 20, 2014

Financial Leverage 101

Told the boys about financial leverage. Used the example of buying a house with 100% of your own money versus a 20% downpayment and 80% mortgage. When you sell the house, your return can be a lot better if you have the leverage of the mortgage. Of course, you need to factor the cost of the mortgage, i.e., the interest, and the risk that if the value of your investment goes down you might end up owing more money to the bank than your investment is worth.

Sometimes people use leverage because they have no choice. They simply don't have the money to buy the asset without borrowing. Sometimes they do it for the better expected financial return - if they think they can invest the rest of their money in something else that will give a better return than the cost of the loan.

A bit of leverage can be good, and sometimes represent's "free money". For example, interest expenses on home mortgages are tax deductible. That tax deduction is an incentive from the government towards home ownership and is, in essence, free money. Of course, even with that benefit sometimes you are better off not borrowing, say, if the interests are too high, or not buying, say if renting is a better route. So it is important to always keep the big picture in mind.

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