Leveraging Debt to Build Wealth
In America we are very accustomed to debt. In fact we are so accustomed to it that we typically are more interested in what our monthly payment will be instead of the actual amount that we are spending. There comes a point along the way though that payments become more and more difficult to manage; the more debt that a person takes on the more risk there is in the situation for the lender and consequently to the borrower as well. Ultimately the lender has the law on their side to get their money back, but where does the borrower go? Of course the lender may not see their money again either if they borrow money to someone who has taken on too much debt, a case that is all too common.
“Leverage is any technique that amplifies investor profits or losses. It’s most commonly used to describe the use of borrowed money to magnify profit potential (financial leverage), but it can also describe the use of fixed assets to achieve the same goal (operating leverage).” – Merriam-Webster.com-
“Overextend: to extend or expand beyond a safe or reasonable point; especially : to commit (oneself) financially beyond what can be paid.” –Merriam-Webster.com-
The two terms “leverage” and “overextended” or probably two terms that you have heard of that you may not have completely understood, but basically speaking leveraging is used to add financial weight to your side of the fulcrum by using debt to purchase something. If you have leveraged too much then you have become overextended and you cannot pay what you have borrowed. This is a simple explanation, but hopefully it clarifies things a little bit.
Disclaimer: You may be thinking this doesn’t apply to you as you continue reading, but before you check out completely jump to the section titled “Everyday Example of Leverage” and see how people do this all of the time without realizing it and it catches up with them overtime.
Think back to your playground days for a moment and the teeter totter or the see saw or whatever you called it. If you have ever played on one you know that in order to make it work properly you need to have the same weight on each side otherwise someone is going for a ride while the other person is doing all of the work to try to get the other person’s side to go down.
If you have ever been on a teeter totter and had this happen then there are two things that can be done to fix this problem: either weight can be added to the lighter side in order to balance things out or the weight on the heavier side can move closer to the fulcrum point, the middle, in order to give the lighter side more leverage.
This is a good example of both the terms leverage and overextended. In this picture the small child is further away from the fulcrum, or the log in this picture, extending him out. The smaller the child is the further from the fulcrum he will have to be. Eventually though if there is too much weight on one side the lighter side will not be able to lift it or will barely be able to lift it.
Using debt to build wealth, or leveraging, causes the same thing to happen. The problem with this is that leverage multiplies returns. So let’s think back to the teeter totter again. If you, as the borrower, are the smaller child in this picture and your investment does well you have weight added to your side and you are able to lift the opposing weight easier. However, if your investment does poorly you lose weight from your side and now the loss that you have incurred has caused you to no longer be able to lift the other side.
To better understand financially speaking, if you use debt to leverage an investment or to build wealth and you experience gains then you see a bigger return on your investment. If you invested $100 of your own money and borrowed $900 to purchase and investment of $1,000 then you are leveraged at a rate of 10:1, you or for every $1 you invested with your own cash you were able to invest $10 by using $9 of borrowed cash. So if the value of your investment rises to $1,500 you will have made $600 off of your $100 investment after you pay back the $900 that you borrowed. So by using leverage you were able to make $600 using $100 of your own money rather than making $600 using $1,000 of your own money.
The problem with this is that investments see can see growth, but they can also see decline. If the investment falls from a value of $1,000 to $500 your investment lost $500 and you still owe your lender their $900. Not only did you lose your initial $100 investment, but it cost you an extra $400 because you used leverage. $400 may not seem like a lot of money, but what if instead you had $10,000 of your own money and borrowed $90,000 and the same thing happened? Your investment of $100,000 is now worth $50,000 and you have lost a total of $50,000, not only did you lose the $10,000 that you invested of your own money, but you still have an additional $40,000 to repay your lender.
These numbers are not taking into account the interest rate of the borrowed money which would change the numbers a little, because you will not be able to borrow money without having to pay interest, but you get the general idea. Maybe you are thinking you wouldn’t borrow $90,000, but you might do $9,000. You would still end up losing your initial $1,000 and you would still owe $4,000.
Obviously a swing in the market like that is not typical, but it does happen. The volatility of the investment has a huge impact on the amount of risk that leveraging creates, but leveraging increases both the risk and the opportunity for gain. You must realize that using leverage multiplies both the potential for gain as well as the potential for loss.
Everyday Example of Leverage
Maybe you wouldn’t ever borrow money to use to invest, but what about to buy a car? Would you buy a brand new car? On average a new car will lose 11% of its value the moment you drive away from the lot which means that if your car was worth $30,000 when you bought it then on average it is only worth $26,700 the moment you leave the dealership.
If you take out a 5 year loan to purchase your car the average car will have dropped 63% in value and your $30,000 is now only worth $11,100 meaning that you lost $18,900 in 5 years. Cars are not an investment so this isn’t actually leveraging, but the idea of using debt to get ahead or to build wealth remains. You may have gotten a zero percent interest rate, but it wasn’t a good deal, especially since you most certainly paid full price.
What’s the alternative? Buy used and pay cash. Loans will cost you money but so will buying too new of a car. You may be arguing that older cars have increased maintenance costs as well and you don’t want to do that, so save up and buy a car this is only a couple of years old. No matter what most vehicles are not investments unless you are the mechanically inclined person who is able to spot a good deal, clean it up and turn around and sell it for more money.
Anytime you make a purchase with money that is not yours you increase your level of risk. If you take on too much risk you will become overextended and will struggle to pay what you owe or worse yet will be unable to pay your debts. While borrowing money to buy a car for personal use is not technically leveraging it is if you borrow money to try to turn around and sell it to make a profit. You potential for gain and loss still exist and your risk is multiplied because you are working with borrowed money.
There are plenty of people, financial advisors and investment advisors included, that will recommend you use leverage in order to invest, but using leverage or borrowing money to invest greatly increases your risk. The best way to invest is with cash and to continue doing it overtime. The earlier you can start investing the better off you will typically be, assuming your investment has not gone belly up. The longer you wait to invest the more of your own money you will have to invest in order to make the same amount of money.
For more info on how interest works to you advantage check out, When Should I start Saving for Retirement.
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