What is... | June 11, 2014

What is leverage?

When home buyers put down a deposit to take out a mortgage loan several times larger, they are using leverage. Sometimes referred to as gearing, leverage can give borrowers significant financial power, multiplying gains.

But it is a double-edged sword, as leveraged borrowers can also lose money – with multiplied losses sometimes amounting to even more than the original investment.
Not being aware of the risks involved in leverage can entice people to borrow more than they can handle. And thinking traps – such as the endowment effect that skews the way people think about something they own – can also play a role in risky borrowing.

Borrowing can multiply your gains – and your losses
If a house buyer uses a €60,000 mortgage deposit on a €300,000 home, they need to borrow €240,000. They then have leverage of four times (the 80% loan is four times larger than their 20% deposit).
They are leveraging their savings to access a bigger asset.
However, if the price of the property drops – and 20%-plus falls have happened in some locations in the past – the mortgagor may end up losing their deposit and still having to pay off a large loan. ING Group chief economist Mark Cliffe warns to be wary of this type of borrowing in his first video lesson from the financial crisis.
“Leverage cuts both ways. Just as borrowing can multiply your gains, so it can multiply your losses,” said Cliffe.

Leveraging for business
More experienced investors might use leverage for foreign exchange trading or via futures and options contracts –highly risky investments given that some carry the risk of losing several times the original sum.
Owners of businesses sometimes also borrow to grow. A company with much more debt than equity is generally described as "highly leveraged".
Like with individuals, leverage multiplies risk too. So being highly leveraged is often considered to be a warning sign about the financial health of a company.
Although if a company borrows money to modernise or expand internationally, the additional diversification might offset the risk from leverage.

Leverage and the global financial crisis
Excessive leverage is said to have played a role in the global financial crisis that started in 2007.
In some parts of the United States, for example, high levels of borrowing on homes became a very big problem when house prices fell dramatically.
The bank Lehman Brothers famously went bankrupt in 2008, due in part, wrote The Daily Telegraph, to a large number of defaults on subprime home loans in the United States.

Beware of leveraging your emotion
People may “gear up” for many reasons and end up borrowing more than they might be able to handle.
They may notice friends buying expensive homes and think they should do the same. In other cases emotion may overcome financial planning and people may endow the thing they are buying with attributes it does not have.
A simple way to reduce your leverage is to borrow less or, if possible, save more. But faced with the house of our dreams (but a price tag firmly rooted in reality), it can be tempting to ignore this prudent message and give in to emotion.
Before borrowing too much – stress test how you would cope financially if your income fell significantly or interest rates on borrowing rose.
It can help to make decisions in a “cold state” of mind, out of the heat of the moment.


eZonomics team
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