Glossary · Funds and derivatives
Leverage
Leverage means using borrowed money to make a bigger investment than your own money allows. It multiplies both gains and losses.
Also called: financial leverage, gearing, borrowing to invest, buying on margin
From its previous high to Jun 1932, monthly average prices: far more than the 50% that wipes out a 2× position.
In plain words
A lever lets you lift a heavy stone with a small push. In finance, leverage lets you control a big investment with a little money of your own, by borrowing the rest. Buy a $400,000 house with $80,000 of your money and a $320,000 mortgage, and you are leveraged five times.
It works beautifully when prices rise. If the house goes up 10% to $440,000, your $80,000 has become $120,000: a 50% gain. It works just as hard the other way. If the house falls 20%, to $320,000, your $80,000 is gone, though you still owe the full loan.
That is the rule of leverage: it multiplies the move in your own money by the leverage ratio, in both directions. And borrowed money costs interest, so the investment must earn more than the loan costs just to break even.
Example
Leverage on a home
You buy a $400,000 home with $80,000 down and a $320,000 mortgage: 5× leverage.
- Prices rise 10%: the home is worth $440,000. Your stake: $440,000 − $320,000 = $120,000, +50%.
- Prices fall 10%: $360,000 − $320,000 = $40,000, −50%.
- Prices fall 20%: $320,000 − $320,000 = $0. You still owe the bank $320,000 and own a home worth exactly that.
- Interest, taxes and selling costs are left out: in real life they make the gains smaller and the losses bigger.
Leverage ratio = what you control ÷ your own money. Your gain or loss ≈ the price move × the leverage ratio.
One level deeper
Leverage is everywhere. Mortgages are leveraged; US brokers let investors borrow up to half the price of shares (buying on margin); futures need only a 5–15% deposit; companies borrow to boost returns to shareholders; banks lend out many times their own capital. In 2007 the investment bank Lehman Brothers held about $30 of assets for every $1 of its own capital; a 3% fall in their value would have wiped it out, and in 2008 it went bankrupt.
The danger is not only the size of a loss but its timing. When prices fall, lenders ask for more money (a margin call) or sell the investment for you, often at the worst moment, so a temporary fall becomes a permanent loss. Many leveraged investors are forced out before prices recover.
Leverage also affects whole economies: borrowing booms push prices up, and when they unwind, forced selling can turn a fall into a crash, as in 1929 and 2008.
Leverage multiplies the move
The return on your own money for a given move in the price of what you bought. At 2× a 50% fall wipes you out; at 4× a 25% fall does.
The numbers behind the chart
| No leverage (1×) | 2× leverage | 4× leverage | |
|---|---|---|---|
| −50% | −50% | −100% | — |
| −45% | −45% | −90% | — |
| −40% | −40% | −80% | — |
| −35% | −35% | −70% | — |
| −30% | −30% | −60% | — |
| −25% | −25% | −50% | −100% |
| −20% | −20% | −40% | −80% |
| −15% | −15% | −30% | −60% |
| −10% | −10% | −20% | −40% |
| −5% | −5% | −10% | −20% |
| 0% | 0% | 0% | 0% |
| +5% | 5% | 10% | 20% |
| +10% | 10% | 20% | 40% |
| +15% | 15% | 30% | 60% |
| +20% | 20% | 40% | 80% |
| +25% | 25% | 50% | 100% |
| +30% | 30% | 60% | 120% |
| +35% | 35% | 70% | 140% |
| +40% | 40% | 80% | 160% |
| +45% | 45% | 90% | 180% |
| +50% | 50% | 100% | 200% |
Why it matters
Most homes are bought with leverage, so house prices and mortgage rates shape family wealth.
Leverage is behind most financial blow-ups, from 1929 to 2008: losses on borrowed money force sales, and sales push prices lower.
Companies’ debt levels decide how badly a downturn hits them and their shareholders.
A common mistake
Myth: With leverage, you can lose only what you put in.
In fact: If prices fall fast, your losses can exceed your own money and you owe the rest. A home that falls below its mortgage leaves the owner in debt; a trader whose position gaps through their margin can owe the broker money.
Questions people ask
What is a leverage ratio?
What you control divided by your own money. $50,000 of stocks bought with $25,000 of your own and $25,000 borrowed is 2× leverage; a home bought with 20% down is 5×.
Is leverage good or bad?
It is a tool. It lets people buy homes and companies invest, and it makes losses bigger and faster. How much is too much depends on how much the investment can fall and how long you can hold on.
What is buying on margin?
Borrowing from your broker to buy securities, using them as collateral. In the US you can usually borrow up to half the price (the Federal Reserve’s limit since 1974); if the value falls too far you get a margin call.
Read more on BigCapital
About the numbers
- The numbers on this page are recalculated from the data every night; the sources are listed at the end of the page.
- S&P Composite price and total return since 1871, and US consumer prices: Robert J. Shiller, Online Data (shillerdata.com); total return with dividends reinvested monthly, calculated by BigCapital.
- This page explains a term. It is not investment advice.