Quote:
Originally posted by legion
A comment on the RE thread got me thinking...
When one can buy an asset with leverage, does that allow the price of the asset to become detached from its intrinsic value?
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No, leverage is just buying an asset w/ a relatively small cash deposit and hoping that the asset will appreciate in value. If it does you still only owe the contract price less downpayment and interest expenses. The 100% subsequent appreciation is realized when the asset is sold. Your cost becomes only the subsidized interest on the loan.*
Leverage works both ways
buying a house is generally good leverage because you get to live in it and get the benefit of the appreciation
buying a car is generally bad leverage because even though you do get the use of it, it is a depreciating asset which becomes a realized loss when it's sold. Here your cost is the principle amount less interest(if any) and depreciation.*
*ignoring maintainance and taxes
W/ stocks it works the same
buy a $10 stock w/ $1 cash and $9 loan*
if it appreciates to $20 sell, you get $20 - $9 - interest on the loan(say $1) = $10 net on a $1 investment thats 1000% gain as oposed to a 100% gain if you paid cash for the original $10 stock.
Of course if it depreciates then you are in trouble.
*ignoreing brokerage fees and taxes