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 one were only to invest using internal cash flows.
For example, an individual can borrow $1,000,000 at an interest rate of 8% and invest the funds at 10%. The 2% differential is positive leverage that will result in net income of $20,000 for the person, prior to the effects of income taxes.
However, 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 both of the following factors are present:
- 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. 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.