Debt and leverage are related financial terms often used to analyze the state of a business, particularly for investing purposes. But individuals also engage in leverage when they borrow money to acquire new assets. At its most basic, leverage is the use of debt to purchase something.
Debt and Leverage Basics
Debt simply is money that someone owes. Debt often originates when a borrower seeks a loan. In return for the debt, the borrower will pay interest to the lender. The interest is the cost of the debt. Not all debt results in leverage. Leverage occurs only when debt is used to buy assets that can appreciate in value, so debt to pay bills or buy products or services often does not qualify as leverage.
Leverage allows an individual or a group of individuals to buy something without paying for it solely with assets they already own. It particularly makes possible large purchases when necessary funds are not available. Profits on purchases that are made with leverage become multiplied by the arrangement. The reason is that any growth in the value of the purchase starts for the borrower not at the borrower's initial investment, which was a fraction of the purchase price, but at the total investment.
Using leverage to finance a purchase carries risk. For instance, if an investment does not go well, the borrower must make payments on the debt without having the profit to offset it. The ongoing costs can become a heavy burden to bear. If the borrower cannot make the necessary payments, the lender often can take ownership of the investment, leading to a total loss for the borrower.
Individuals use debt and leverage to make many types of purchases. For example, an individual can take on debt by taking out a mortgage to buy a home. That home qualifies as an asset, so the purchase is the result of leverage. Young borrowers often take on debt for such agreements as student loans and car loans. Neither of those deals counts as a leveraged acquisition, because neither agreement purchases an asset that can appreciate in value, in contrast to the mortgage.
- George Doyle/Stockbyte/Getty Images