I was asked about financial leverage the other day and ended up explaining it all on the back of a scratch piece of paper.

Because nearly any idea is a good idea for a blog post, I will archive it here too so that I have this post to point to later.

Here goes.

Financial leverage is simply borrowing to increase the overall return of a portfolio.

I mean, assume we are looking at two different assets to invest in: A rent-home and publicly traded ExxonMobil stock.

The rent-home cost $100,000 – and pays a 10% return.

The ExxonMobil stock can be bought in any amount – and pays a 5% return.

Now assume you have $100,000 of money to invest.

The question is: How can this $100,000 be invested to achieve the highest rate of return?

If all $100,000 is invested in the rent-home, the investment will annually produce $10,000. 

This yields a 10% return. (10,000/100,000 = 0.10)

If all $100,000 is invested in ExxonMobil stock, the investment will annually produce $5,000. 

This yields a 5% return. (5,000/100,000 = 0.05)

But what if we use financial leverage?

If $20,000 is invested in the rent-home – the other $80,000 borrowed thru financing – the income is still (approximately) the same, but the return is higher.

This yields a 50% return. (10,000/20,000 = 0.50)

Then we invest our remaining $80,000 in ExxonMobil stock.

This yields a 5% return. (4,000/80,000 = 0.05)

So of our total portfolio, $20,000 is earning a 50% return and $80,000 is earning a 5% return.

Calculating the weighted average yield of this gives us a 14% return.

20,000 * 0.5 = 10,000
80,000 * .05 = 4,000

14,000/100,000 = 0.14 = 14%

A higher return is achieved by leverage than was possible through either original option.

Obviously, more leverage could be used to achieve an even higher return, but this is a trade-off along the traditional risk/reward line.

Understand: Debt can be bad too.