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Concept · Asset allocation

What is leverage?

Direct answer Owning more of an asset than the equity put into it, with the rest borrowed. A house bought with 20% down is levered five times: a 20% fall in its price removes the equity. Leverage multiplies both the gain and the loss on the equity and, for a household, sets the size of the reserve, not the mix of the liquid book.

The mortgage is the leverage most households carry. It does not change what the house is (a fifth of its value in stock exposure, on the Asset allocation page); it changes how much of the household’s net worth the house is, and how a bad year lands. The January 2006 buyer of a Los Angeles house at 20% down had the equity wiped out in 2008; the January 2010 buyer of the same house on the same terms earned 13% a year on equity.

The danger of a levered house is a forced sale, so the reserve, six to twelve months of spending and mortgage payments in bills, is tested against a 30% fall in the house plus a year without income.

Sources

  1. Federal Reserve, Financial Accounts of the United States, household balance sheet (Z.1, table B.101)federalreserve.gov

Used in

The house is stocks, at a fifth of its value A house moves with the stock market at a beta near 0.2, so a $1.5M house supplies $300,000 of stock exposure. Counted, the savings of a household with a house hold more stock than the plain book. The mortgage is leverage, a rate and an option, and it has no price A fixed-rate mortgage cannot be sold, so it has no market value to the household. It is leverage on the house, a fixed rate to compare with today's, and a refinance option that pays when rates fall.

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