Positive leverage definition
/What is Positive Leverage?
Positive leverage arises when a business or individual borrows funds and then invests the funds at an interest rate higher than the rate at which they were borrowed. The use of positive leverage can greatly increase the return on investment from what would be possible if you were only to invest using internal cash flows.
How Risky is Positive Leverage?
Positive leverage can turn negative if the rate of return on invested funds declines, or if the interest rate on borrowed funds increases. Consequently, the concept of positive leverage is least risky when both elements - the borrowing rate and investment rate - are fixed. The amount of leverage is most subject to variability when both elements are variable. In the latter case, an investor can find that investment returns swing wildly within a short period of time.
The best time to take advantage of positive leverage is when the borrowing rate is much lower than the investment rate, and it is relatively easy to borrow funds. When such a "loose money" environment exists, expect speculative investors to borrow large amounts of cash. The best possible situation for positive leverage is when it is possible to lock in a long-term interest rate at a low level, so that there is no risk of the rate increasing for a number of years.
When the lending environment later tightens, expect increasing numbers of these investors to become insolvent as their positive leverage turns negative and they cannot support their liabilities. In a tighter lending environment, at least expect investors to sell off their investments and use the resulting funds to pay back their highest-interest loans.
Related AccountingTools Courses
Example of Positive Leverage
An individual obtains a mortgage on her home at an interest rate of 3.9%. Subsequently, inflation goes up, so the Federal Reserve raises interest rates, resulting in money market funds paying an interest rate of 5.5%. She then receives a $100,000 inheritance. Rather than paying down the low-interest mortgage, she uses the inheritance to buy into a money market fund, thereby receiving a higher effective rate of return. Once the rate of inflation declines and the Federal Reserve corresponding drops interest rates, this will cause the rate of return on money markets to decline - possibly triggering a decision to use the excess cash to pay down the mortgage.