While leverage can amplify gains, it can also magnify losses. If an investment does not perform as expected, the investor must still repay the borrowed funds. Leverage magnifies profits when returns from the asset exceed borrowing costs, but it also magnifies losses. A corporation that borrows excessively may face bankruptcy or default during a downturn, whereas a less-leveraged corporation might survive. An investor who buys a stock on 50% margin will lose 40% if the stock declines 20%, potentially being unable to cover the significant total loss.
Changes in interest rates can affect the cost of borrowing. Rising rates can increase the cost of debt, reducing profitability.
Leveraged positions may require additional capital to maintain. If the investor cannot meet these requirements, they may be forced to liquidate assets at unfavorable prices.
Financial leverage can increase returns, but it comes with significant risks that demand careful management. For further reading, refer to Modigliani and Miller’s Theorem on capital structure and leverage.