In our last episode of As the Leveraged World Turns, (so sorry ’bout that one, really) we talked of what leverage really is primarily — and what it’s (mainly) NOT, which is a low down payment. One of my favorite readers asked if I could give an example, using real numbers.
Gonna make this short and simple so I don’t fall into the War & Peace trap. 
First here’s the gist of of the plot from last time. Real leverage comes from the relationship between the cost of borrowed money and the return on the investment itself. Positive leverage results from the return exceeding the cost of the debt. Negative leverage is then, of course, the other side of the coin.
You borrow $100 from Uncle Dick, who charges you 6%, the normal nephew discount. Immediately you go out and ‘buy’ a $100 note from your buddy, Timm. The note calls for 8% interest.
Each year you receive $8 from Timm, whereupon you immediately send $6 of it to Uncle Dick. You pocket the remaining $2. What you have there, is classic positive leverage.
Note: Have you figured out what’s missing yet?
On the other hand — what if Uncle Dick lent you the $100, same rate, and you lent it to Timm at an interest rate pegged to a particular index, which would
set the rate the following day. It was a gamble, but one you thought prudent, as you were pretty sure the index was gonna rise. Of course, it didn’t. It fell like a rock — finally landing at 5%. You now have a problem, don’t ya?
Each year Timm pays ya $5, a dollar short of what you now owe Uncle Dick for the year’s interest on his loan. You find yourself diggin’ into your pocket for the extra buck needed to make the payment. You just felt the sting of negative leverage.
Notice in this example there wasn’t a ‘down payment’ of any size — you borrowed the $100 and ‘bought’ the note given to you by Timm with the same hundred dollar bill. You own the note free and clear — yet there’s still leverage involved.
And yeah, yer right, free and clear is a stretch here. I know it’s 100% financed by the money lent you by Uncle Dick, but you get the point.
I’ve enjoyed many a free drink proving the existence of leverage in a so-called ‘free ‘n clear’ transaction.
Now, apply this to your typical real estate investment. You might put 20% down plus some closing costs, totaling roughly $50,000. The new 80% loan carries with it a fixed rate of 5.5% interest. Using the same simple arithmetic used in the examples, we find our return is 12% — positive leverage. And, if the property’s return had been less than the cost of your money — 5.5% — your leverage would then have been negative.
The concept of leverage is one of the laws of the physics of economics.
Does all that make sense to ya? Call me at 619 889-7100. Have a good one.
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LOL, good thing you also have Uncle Sam who will come in a force Uncle Dick to modify his loan to you to make it “work” better.
Grin — Everybody’s a comedian.