Financing your investment
Borrowing money to buy assets allows you to buy more property and shares than you could otherwise afford. For example, if you had $40 000 in cash and earned 3 per cent per year in interest in a term deposit, you would earn $1200 in one year ($40 000 × 3 per cent). However, if you used this $40 000 towards the purchase of a $400 000 property and the property increased in value by 3 per cent in one year, the value of your asset will have increased by $12 000 ($400 000 × 3 per cent). This is ten times the profit you would have made if all you did was place your $40 000 in a term deposit. Imagine if the property increased by 10 per cent in one year. You would be $40 000 richer just by leveraging, or using borrowed money, to buy assets!
However, borrowed money can also work against the investor. If you borrowed money to buy the $400 000 property and it dropped in value by 10 per cent, you would lose $40 000. As a result of this drop in value, the property you own is now worth only $360 000. This means you have lost your $40 000.
The same can be said for leveraging to buy shares, except the gains (and losses) can be greater, as the price of shares fluctuate much more than property.
The use of borrowed money gives you leverage — magnifying your potential gains, but also bringing with it greater risk as it magnifies the potential loss. However, without leveraging ...
