While the term “leveraged debt” may seem unfamiliar to you, it is a fairly common practice in personal finances as well as business finances. The term refers to a scenario when a person or business chooses to make a large investment with the help of various financial resources, including borrowed capital. Leveraged debt is used to increase returns on an investment; however, there are serious risks involved.

Examples in Business and Personal Finances

The most common uses of leveraged debt include business, stock, and real estate investments.

In business, leveraged debt is a tool used to magnify returns on large scale operations. For example, if a company has only $1 million in equity, but they believe they can profit from funding a $10 million operation, they may use “borrowed capital” to fund the remaining $9 million. In this scenario, the company is trusting that their operation will be successful enough to make a considerable profit, even after repaying the $9 million in loans.

In personal finances, it is common for people to use leveraged debt when investing in the stock market. For example, if a person feels confident in their ability to do well in stocks, but they do not have the cash they need to purchase shares, they may take out a loan to for the initial investment. If a person borrows $1,000 and invests it with a return of $5,000, they have earned 500% profit.

Purchasing a home is another investment in which people frequently use leveraged debt. For example, if person wants to buy a $100,000 home, but only has $20,000 for a down payment, they make take out a loan for the remaining $80,000. Once they make the purchase, they can begin to rent out the home for, let’s say, $600 a month. After renting out the house for a just two years, they have gained $14,400 in rent. Additionally, if the real estate market does well, their profit margin can increase even more.

Risks Involved

Leveraged debt can significantly increase your investment’s returns; however, it can also increase your losses. When relying on borrowed capital, it is important to thoroughly research your investment, because if it fails you will still be held accountable for the debts you owe, which can often be quite substantial. In the event that you are unable to pay them, you may find yourself filing for bankruptcy.