Experian.com | August 23, 2022 | By Marianne Hayes | Financial Leverage

Quick Answer

Financial leverage is when you borrow money to make an investment that will hopefully lead to greater returns. It’s built on the idea of spending money to make money. Examples of financial leverage can include: Buying a home, investing in a business and buying an investment property.

We’ve all heard the saying, “You’ve got to spend money to make money.” In finance, leverage is when you borrow money to make an investment that will hopefully lead to greater returns. No investment is ever a 100% guarantee—there’s always risk. Financial leverage leans into the idea that borrowing cash to cover a new investment has the potential to pay off in the long run.

Let’s look more closely at how financial leverage works, along with its potential benefits and drawbacks.

How Financial Leverage Works

What is leverage? It has to do with maximizing your advantage. Leverage in personal investing involves using borrowed funds to buy into an investment. It’s widely used in the corporate world as well. Lots of companies, especially startups, continually seek leverage in the form of investor capital they can use to grow their businesses and meet important milestones.

Individual consumers use financial leverage in a different way. Here the focus is on building personal wealth. If you’re an entrepreneur or business investor, that might involve putting money into growing businesses. Otherwise, financial leverage covers any personal investment that’s made with borrowed funds.

Examples of Financial Leverage

Borrowing Money to Buy an Investment Property

Buying an investment property is a prime example of financial leverage. That may be a rental property that you maintain and lease out to tenants, which can create a steady flow of passive income each month. Alternatively, you may fix and flip properties. In this case, the goal is to turn a profit after buying a property, sprucing it up and putting it back on the market.

Both options require upfront capital. In addition to making the purchase, rental properties require ongoing maintenance and repairs. There are also property taxes, homeowners insurance and other recurring expenses.

Flipping homes has its own financial demands. You’ll need funding to complete the purchase and all the necessary repairs and upgrades, which will determine your asking price when you’re ready to sell. Unless you’ve got cash on hand to cover the purchase, you’ll have to take out a loan to buy an investment property. It’s typically more complicated than buying a primary residence, and may require a larger down payment (usually 20% to 30%). Interest rates and credit score requirements are usually higher too.

Taking Out a Mortgage to Buy a New Home

Everyday folks who take out a mortgage to buy a new home are also flexing their financial leverage. That’s because the money you borrow through your home loan is being used to purchase an asset, which is part of your financial portfolio. Every monthly payment you make reduces your loan balance and increases your home equity. This is the amount of your home’s value you actually own. The more equity you have, the more money you’ll pocket when it comes time to sell.

You can also use home equity to unlock financing. This includes a home equity loan or line of credit, as well as a cash-out refinance. Each option allows you to trade equity for upfront cash. You might use it to cover home renovations, college costs, debt repayment or other major life expenses.