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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Suppose you have $1000 to buy stock. Assume you make 5% per year, so at the end of the year you have $1050.
Now assume you have $1000 and you borrow $1000 for a year at 3%. You buy stock with it and make 5% and pay 3% on the loan, so you have $1070 after you pay off the loan.
The problem with leverage is it goes both ways, if you borrow money and then the stock goes below your purchase price, you owe money to the lender.
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