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The recent crisis in world financial markets, which has had a negative impact on pension funds and mutual funds* that you own, is a great illustration of the potential risk of leverage. Leverage is defined as borrowing money to increase returns.
Recent crisis. A huge industry developed in the United States known as sub prime lending which included lending more than 100% of the value of a home often to individuals with less than stellar credit and job stability at low introductory mortgage rates. In the beginning of 2007, the US economy was slowing down and interest rates were increasing which resulted in more and more of these mortgages in default. These mortgages, packaged as financial instruments known as Asset Backed Commercial Paper, were bought and sold. Investors, many of them large financial institutions, who bought these financial instruments, are now realizing that they are only as good as the underlying mortgages they hold and are dependent on borrowers making their payments.
When is leverage a good thing? Many of us have used leverage to purchase a home or a car; others have used leverage to buy a business or rental property. Below are some guidelines in using leverage.
*Mutual Funds are offered through Credential Asset Management Inc. Unless otherwise stated, mutual fund securities and cash balances are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer that insures deposits in credit unions.
®Credential is a registered mark owned by Credential Financial Inc. and is used under licence.
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