Leverage is defined as the process of borrowing money to make an investment, with the expectation that the profits made from the investment will be greater than the interest on the debt.
In my investments in bonds and reits, I like to use leverage. On the other hand, some of my friends stay clear of leverage. They try to pay off their loans as soon as possible.
So is leverage good or bad?
“Give me lever long enough and a fulcrum on which to place it, and I shall move the world.” Archimedes.
Leverage is considered bad by the majority, because
- most are unwilling to pay interest for the loan amount
- they have too much money in the bank doing nothing
- of the potential to lose more than the initial invested amount.
Why then do some, who are probably more financially savvy, believe strongly in leverage?
- Banks’ main income source to is borrow from individuals at low rates and lend to corporations at higher rates.
- Professional traders believe leverage because it gives then ability to trade higher larger positions. Leverage provides efficient use of capital. The higher the leverage, the better.
- Most property investors borrow money from banks to invest in properties. The saavy investors usually do not plan to pay off their loans. A good example are the REITS, who are always borrowing, and they believe in making money using other people’s money.
For me, there is no good or bad in leverage. It depends on
- the risk profile of the investor. A conservative investor should not take higher risk as he will not be able to sleep well at night
- market environment. Does not make sense to leverage if interest rates on the debt are too high.
In my opinion, leverage is neither good or bad. It is simply a tool to use at the right time. It really depends on individual risk tolerance profile and on the market situation.
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