Compound and leverage are two terms that investors from around the world know. While there are a few terms that get thrown around amongst investors, compound and leverage are two of the most important because they directly impact your investments.
What is a Compound Investment?
Compound investments, also called compounding, is one of the most powerful forms of investment possible. This form of investment involves assets that generate earnings that are:
- Reinvested in the same asset
- Earn their own earnings
Let’s assume that you have a $100 investment that earns a 10% return rate annually. After the first year of investment, the asset would be worth $110. The $10 was put back into the investment, so now you have an asset that is earning 10% interest on $110.
In year two, the investment would swell to $121 and continue earning more money each year.
Your investment is working for you in this case. Why is this important? Your investment will keep earning money, swelling your portfolio and helping you accumulate wealth in the process.
Imagine you invested $10,000 and returns were 10% per year. By the 25th year, if you didn’t invest a single dime more, you would have almost $110,000 sitting in your account. Of course, the rate of return will vary from one investment to the next and may not be 10%.
Compound interest can be beneficial, but it can also go against you in terms of a loan. Compound interest can add interest to your loan, often seen with credit cards, where you’re paying off a significant amount of interest per month due to compounding.
A compound interest calculator can help you visualize how your money can grow.
What is a Leverage Investment?
Leverage uses debt or capital that is borrowed to increase in investment. For example, if you took out a mortgage on a home, this would be considered leverage. The idea behind leverage plays a role in a lot of consumer purchases, and while investors always hope for a return, they may also suffer losses.
- Housing prices could fall, causing you to owe more on your home than it’s worth
- Rental units may not generate the income expected, causing the value of the property to drop and leverage to work against you
When talking about leverage, this is borrowed capital or a financial instrument that you’ll use to increase your return on an investment.
Investors often put down as little as possible on a home because they want as much of “other people’s money” to be put in the home as possible. There are pros and cons to leverage, such as the value declining.
An apartment complex that is worth $1 million at purchase and has declined to $700,000 still requires the investor to pay interest and principal on the full $1 million loan no matter what the current price of the complex may be.
Proper risk assessment can help you understand if leverage is a good option on a specific property or not.
Once you understand compound and leverage, it’s possible to invest with more success. You’ll be able to use both of these tools to grow your investment portfolio year after year.