Why Does Using Leverage Increase Financial Risk?
Explore how using borrowed capital in finance amplifies returns and losses, fundamentally increasing risk.
Explore how using borrowed capital in finance amplifies returns and losses, fundamentally increasing risk.
Leverage, the use of borrowed capital to finance assets or investments, is a pervasive element across the financial landscape. From individual home purchases to large corporate expansions, debt often plays a significant role in funding activities. While leverage can enhance potential returns, it fundamentally alters the risk profile of an investment or business. This relationship between borrowed funds and heightened risk is a central concept for anyone navigating financial decisions.
Leverage involves employing borrowed money to acquire assets or make investments with the expectation that the returns generated will exceed the cost of borrowing. It allows an entity to control a larger asset base than its own equity would otherwise permit. For instance, an individual might use a mortgage to purchase a home, controlling a property worth hundreds of thousands of dollars with a down payment representing only a fraction of the total value.
The primary purpose of using leverage is to amplify the potential returns on equity. If an investment performs well, the profits are distributed over a smaller initial equity contribution, leading to a higher percentage return. This magnification principle is foundational to understanding why businesses and individuals seek out leveraged positions.
Leverage amplifies outcomes, magnifying both gains and losses. When an investment financed with borrowed funds performs favorably, the returns on the owner’s equity can be substantial, as the borrowed capital contributes to the overall profit without requiring a proportional equity investment. For example, if a property purchased with a 20% down payment increases in value by 10%, the equity portion of the investment could see a 50% return.
Conversely, this amplification effect means losses are also magnified. If the underlying asset or investment declines in value, the percentage loss on the equity portion can be significantly larger than the percentage decline of the asset itself. Even a small drop in the asset’s value can erode a substantial portion, or even all, of the initial equity. This is because the debt obligation remains fixed, regardless of the asset’s performance.
Should losses become significant and sustained, they can lead to severe financial distress. In investment accounts, this might trigger a “margin call,” where a brokerage firm demands additional funds or securities to meet minimum equity requirements. Failure to meet a margin call can result in the forced liquidation of assets, potentially at unfavorable prices, which can lead to losses exceeding the initial investment. Businesses might face default on loan obligations, potentially leading to bankruptcy if they cannot service their debt.
Leverage is common in personal finance, business operations, and investment strategies, each with distinct applications and risks. In personal finance, a common example is a home mortgage. Borrowers typically make a down payment, which can range from 3% to 20% or more of the purchase price, and finance the rest with a loan. While this allows individuals to acquire a valuable asset, rising interest rates, especially for adjustable-rate mortgages, can increase monthly payments and financial strain. If property values decline, the homeowner’s equity can quickly diminish, potentially leaving them owing more than the home is worth.
Businesses frequently utilize debt financing, such as bank loans, lines of credit, or bonds, to fund operations, expand, or acquire assets. For example, a small business might secure a Small Business Administration (SBA) 7(a) loan, which can be up to $5 million, for working capital or real estate. While interest payments on business debt are often tax-deductible, these loans create fixed financial obligations that must be met regardless of the company’s revenue or profitability. If revenues decline or unexpected costs arise, the fixed debt payments can strain cash flow, potentially leading to default and damage to the company’s credit rating.
In the investment world, investors use margin accounts to borrow funds from a brokerage to purchase securities, or employ derivatives to control larger positions with less capital. Federal Reserve Board Regulation T generally allows investors to borrow up to 50% of a security’s purchase price for new purchases. This enables amplified gains if the securities appreciate, but it also means that a relatively small percentage drop in the security’s value can lead to significant losses on the invested equity. The Financial Industry Regulatory Authority (FINRA) requires a minimum maintenance margin, typically 25% of the total market value of securities purchased on margin.