Okay, I know basic math and I see the numbers, but I’m an economic idiot because I fail to see how taking bigger loans cause higher profits. What is the leverage effect and why do I want to make use of it?
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Loans are a means to an end. If the money obtained from the loan is wasted or used on bad investments, then there will not be increased profits. The underlying idea is that if the money obtained is used properly, then the increase in profits will exceed the cost of the loan (ie the interest payment).
An example. Say a farmer can make $1,000 profit from an acre of land per year. Each plot of land costs $10,000 to purchase. The interest rate is 5% so the cost of borrowing $10,000 is $500 a year. If the farmer can borrow $100,000 then they can purchase 10 acres of land and get $10,000 more profit. The cost of the loan is $5,000 – therefore the net additional gain to the farmer is $5,000 per year by borrowing $100,000.
Now if the farmer borrows $100,000 and uses it buy a vacation villa, that will clearly not increase their profit.
Loans are a business tool. Used wisely, it can increase profit; used badly, it won’t increase profits.
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