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The Basics of Leverage

by SMD 


Leverage:

The financial advantage of an investment that controls property of greater value than the cash invested. Leverage is usually achieved through the use of borrowed money. [quote from here]

I want to run through an example of leverage. This example is driven by the fact that the leveraging is happening from inside a company [either a corporation or proprietorship]. So, in reality this example has two methods of accelerating your money combined.

Let’s say you use $25,000 of your company’s funds to purchase a property worth $250,000. This is the first and most obvious use of leverage, since you have only used a 10% payment to control 100% of an asset. Most people are familiar with this technique since it is used to purchase most residential homes.

But it gets better: depreciation. Since you purchased the asset within a business and depending on the type of asset, a certain percentage will be depreciable. That’s a percentage of the full amount! Here’s an example. Let’s say you are entitled to a 3% depreciation on the $250,000 property per year. That amounts to a $7500 tax write-off in year one. If you are being taxed at a 30% rate (30% of 7500/25000) it will yield a direct saving of $2250. That represents a 9% return on your original investment of $25,000 just in the depreciation on the property. This is thanks to the fact that the tax break occurs against the leveraged amount of the entire investment.

Leverage advantage #3. You get the appreciation on the full amount of $250,000. So if the property goes up 10% you have made $25,000 (minus taxes if applicable) which represents a 100% return on the original investment. In addition, if the property goes down in value, then, because the investment is a business asset, the loss becomes tax deductible as well.

So clearly, in the case of real estate leveraging is a great tool. When combined with holding assets in a business structure and proper tax planning it becomes a very powerful financial accelerator.
Final thought:

“If you’re working hard physically and not getting ahead financially, then you’re probably someone else’s leverage!” -RichDad

Leveraging can also be used in other ways such as options trading in stocks and currency.

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Comments

2 Responses to “The Basics of Leverage”

  1. Anthony French on December 15th, 2008 6:27 pm

    I am amazed daily at the lack of knowledge on using the basic financial principles. It is clearly evident to me that the basic priciples, time value of money have completely gone out the window. When are you guys going to wake up and tell the American public that its not possible to finance your way out of debt. It is time to tell the truth. With the state of our economy sometimes businesses large and small must fail. Thru failure business men learn. To the American public and business leaders we have become the golden parcute for the large business world. And for government you can’t spend more than you take in. Budgets are only a guideline for expected expenses. To really correct this mess it must happen by the consumer spending habits must change and we can’t be the safety net for bad business decisions. Sub Prime loan did cause this mess the lack of consumers understanding the time value of money did. Invest in a $ 45.00 HP 10 B II financial calculator, learn how to use it, it comes complete with a CD and manual book. You will be glad you did.

  2. Migell on August 5th, 2011 9:54 am

    In my opinion a massive “Financial Advantage Leverage Tool” to put in use to de-clear the USA DeadLine Crisis Debt Deal would be to get into the table the most ’50 Biggers’ corporations to check-up how and what they are able to share with the ‘common taxpayer’ populatiion in order to save their backs from pulling the whole load alone. It doesn’t have to be to difficult to do, really!

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