Leverage

Leverage allows a person or company to control assets worth more than their own money. The extra comes from debt or from financial instruments that provide large exposure for a small upfront payment.

Consider an investor who buys a 200,000 property with a 40,000 deposit and a 160,000 mortgage. If the property rises 10% to 220,000, the investor's equity grows from 40,000 to 60,000, a 50% gain on their own money. If it falls 10% to 180,000, their equity shrinks to 20,000, a 50% loss.

Companies use leverage too, borrowing to fund expansion. If the borrowed money earns more than the interest cost, shareholders benefit. If it earns less, or if profits fall, the fixed interest payments can become a heavy burden.

Leverage is often measured with ratios, such as debt to equity or debt to earnings. High leverage increases the risk of financial distress. Many financial crises have involved investors, banks or companies that borrowed too much and could not cope when asset prices fell.