Financial leverage is the strategy of using borrowed money to increase exposure to an investment's returns. Investors and businesses regularly use debt as a tool to increase their holdings and generate income — but it's a double-edged sword.
Used well, leverage can accelerate wealth-building; used poorly, it can leave you worse off than investing without borrowing. This article explains how financial leverage works, common ways it's used, and what you need to know before considering it.
What is financial leverage?
Financial leverage is when you borrow money to buy investments, with the goal of earning more than the cost of borrowing. By using debt to purchase more assets than you could afford with cash alone, you can amplify both your potential gains and your losses.
However, leverage increases both potential gains and potential losses. It can boost returns when asset prices rise, but it can deepen losses when prices fall.
The higher the leverage, the higher the risk. As borrowed funds rise relative to equity, losses can outpace your initial investment and you may still owe the lender.
How financial leverage works
Both investors and companies can use leverage to acquire investments. A company might use financial leverage to buy another company because it believes owning the other company will make them more money than it costs to service the debt of the purchase. An investor might use financial leverage to borrow money for buying more shares of a stock than they could with their own cash.
Investors and companies can use leverage in different ways—for example, investors may use margin accounts, futures, options, or bank loans, while companies may borrow from banks or issue corporate bonds.
In order to confidently take on financial leverage, a company or investor should feel good about two things:
1. The asset is expected to generate enough return to cover interest and repayments. 2. The asset is unlikely to fall enough in value to trigger losses that the borrower cannot cover while still owing the lender.
Though any investment comes with some level of risk, if the asset doesn't meet these conditions to start with, then taking on financial leverage can be even riskier. If an individual investor is over leveraged using a margin account, for example, they will face a margin call, and be required to fund their account.
If servicing debts eats up a lot of their financial resources, investors and companies are considered highly leveraged. If servicing debts exceed their available financial resources, they're considered over leveraged.
Common ways investors and companies use leverage
Leverage isn't limited to professional investors; it appears in many areas of finance:
Investors may use margin accounts, where a brokerage lends money to buy more stocks. They may also use options or futures contracts to control a larger position for a smaller upfront cost.
Companies use leverage to fund growth. Instead of issuing more shares (which dilutes ownership), they might issue bonds or take out loans to build a new factory or acquire a competitor.
Homeowners use leverage when they take out a mortgage. A 20% down payment allows you to control 100% of the property, amplifying your returns if the home's value increases.
Types of leverage: operating vs financial
It's easy to confuse different types of leverage, but they work differently:
Financial leverage | Operating leverage | |
|---|---|---|
| What it is | Using debt to finance assets | A company's fixed vs. variable cost structure |
| How it works | Borrowing money to buy more investments | High fixed costs that amplify profit changes when sales fluctuate |
| Risk factor | Harder to repay debt if investments lose value | Fixed costs remain even when sales drop |
Financial leverage is about how you fund activities. Operating leverage is about your cost structure. Both amplify outcomes — but in different ways.
How to measure financial leverage with ratios
To figure out how much debt a company is using, investors rely on leverage ratios. These formulas help compare companies within the same industry.
Debt-to-equity ratio (D/E)
This is a common metric. It compares a company's total liabilities to its shareholders' equity.
Formula: Total Liabilities ÷ Total Shareholder Equity
What it means: A D/E of 1.5 means the company has $1.50 of debt for every $1 of equity.
A higher ratio generally means higher risk. However, "high" is relative — utilities often have higher D/E ratios than tech companies because their cash flows are more stable and predictable.
Examples of financial leverage
Let's look at how financial leverage works in practice, using a simple personal investing example involving a bank loan.
Your friend Tom believes he has found a low-risk investment opportunity and wants you to participate. (For clarity: investment returns are never guaranteed; this is a simplified illustration.)
He promises to return your money, plus an additional 50% after 1 month. But you only have $1,000 to invest.
So, you borrow an additional $4,000 from your bank. They want $120/month in interest. You give $5,000 to Tom and he returns $7,500 a month later (turns out it was a good opportunity).
You pay the bank its $4,120 (the loan plus 1 month's interest) and pocket the remaining $3,380. If you'd invested only your own cash, you would've earned $500. By borrowing money from a lender, you earned $2,380.
That's an example of how financial leverage can be used to increase your returns. But what if Tom was wrong, and the investment opportunity wasn't so great?
After 1 month, your $5,000 investment is gone. You need to pay the bank $4,120 (the money you borrowed, plus 1 month's interest). Plus, you lost your own $1,000.
That scenario highlights the risk of leverage. If investments fail, you can be left dealing with substantial losses.
Advantages and disadvantages of financial leverage
Before you start borrowing money to buy stocks or invest in exchange-traded funds (or anything else), it's important to understand the pros and cons of financial leverage.
Pros of financial leverage
Financial leverage can increase buying power by allowing you to invest more than you could with cash alone.
It can provide access to investments that might otherwise be out of reach.
It can increase potential returns if the investment performs well and the gains exceed borrowing costs.
Cons of financial leverage
Losses can be larger. If returns do not exceed borrowing costs—or if the asset falls in value—your losses may increase.
Interest payments reduce returns and can add to losses if the investment underperforms.
Higher debt can reduce flexibility by limiting your ability to invest further, qualify for financing, or manage unexpected expenses.
Final thoughts on financial leverage
Borrowing to invest is inherently risky because it amplifies both gains and losses. Before you consider using financial leverage, make sure you're confident in your investments and your ability to handle potential losses. If you're ready to start investing—with or without leverage—consider opening an account with a regulated brokerage that fits your needs.
