Leveraged debt. The very word strikes passion and controversy. There are two main camps: adamantly for it or against it. Very few people are in the middle.
Some personal finance experts and investors say it’s the only way to go because of the potential outsized returns. Others say to avoid it because the consequences are so severe if you mess it up by going too fast, lack the knowledge, have too many blind spots, etc.
What is Leveraged Debt?
Before we get too far into leveraged debt, it’s important to give a basic definition. Leverage itself is using something to get an outsized return. And leveraged debt is using a lower amount of money to get an outsized return.
For example, 20 percent down on a house (primary or rental) is using leveraged debt because 80 percent of the property is financed. Either the bank or another lender is fronting 80 percent of the money while you only pay a small percentage upfront. You still get the house and everything that comes with it like appreciation, rent gains (for a rental), etc.
What It’s Not: Can’t Leverage Consumer Debt
One thing that leverage is not is consumer debt. You cannot leverage consumer debt because it provides no gains or returns. A financed couch or TV isn’t an asset that is going to go up in value or be rentable. Unless it’s part of a short-term rental business, in which case it’s not consumer debt to begin with.
So credit card debt, store credit, etc. are all consumer debt that is not considered leverage. The only type of leveraged debt is income producing assets like real estate, stocks, or other types of investments.
Related:
The Double-Edged Sword Is Sharp
Search for leveraged debt online or on social media and you’ll find a ton of influencers talking about it being the pathway to riches. Leverage, leverage, leverage and you’ll be able to use other people’s money (like the bank or investors) to gain massive wealth. Which can be true.
What people are not telling you is that leverage is a double-edged sword. And that sword is razor sharp and very dangerous. Use the sword correctly and it’s a great tool. A false step or two and the sword will become a tool that cuts the user.
For example, leverage is often used in real estate. Purchase a $100,000 rental property with 20 percent down and you control a $100,000 asset by only using $20,000 of your own money. You get the growth, so if that property doubles in the next 10 years, you now control a $200,000 property while not having to contribute any more money. Great, right?
This is great when it works, but what happens if the property doesn’t rent as quickly as you thought, has unexpected repairs, insurance costs rise, property taxes rise without rent growth, or you get a variable interest rate that doubles? Now leverage is working against you because you’re losing money monthly on the property. Hopefully temporarily, but it can be permanent.
Point is, leverage is a double-edged sword and there are risks to it that not everyone is aware of or wants to tell you about.
Big Rewards and Catastrophic Losses
Leveraged debt has the ability to produce massive rewards. It also has the ability to produce catastrophic losses. Let me give you an example of both:
In 2009, I purchased my first property. A one-bedroom condo in San Diego that I was going to make my personal residence. I lived in it for about four years and began renting it out once I purchased a house. That condo has appreciated by about four times the amount I bought it for.
If someone had purchased five of those same condos in 2009, they would have well over a million in equity between the five units and really good monthly cash flow. That’s massive growth and the power of leverage would have allowed them to buy multiple properties using mostly the banks money.
Now let’s use an example of when leverage can result in big losses. A real estate investor who purchases five units in another complex with a variable interest rate. The property goes well for the first couple years until interest rates start to rise. Their original 3.5% interest rate has now spiked to 7%.
As a result, payments have risen by over $700 per property. Multiplied by five properties, that’s $3,500 more in interest payments alone, quickly taking cash flowing properties into cash-sucking properties. The owner would need to find some solution to stay afloat like selling the properties, refinancing with private lenders, etc. Not a great spot to be in.
Your Temperament
There’s a big piece not often talked about in personal finance matters–your temperament. If you’re the type of person who can handle the risks of leveraging debt, the strategy is more appropriate for you.
But if you’re the type of person who hates debt and would be very nervous using leverage, it’s not the best strategy for you. Leveraging debt is only going to make you nervous and anxious, defeating the purpose of acquiring assets.
Money and the acquisition of assets is supposed to make your life easier and more enjoyable. Don’t flip this on its head by getting yourself into an investment strategy that will make you feel the opposite.
Life Goals
In anything you do, whether it’s financial or something else entirely, life goals matter. Your actions have to be aligned with your life goals. If one of your goals is to acquire a large amount of assets in a set window of time, leveraging debt is a strategy to consider.
If you’re someone whose life goal is to remain debt-free, then leverage hinders that goal. Leveraging debt also comes with effectively managing that debt as part of your financial strategy. Which is out of alignment with being debt-free.
If you’re going to leverage debt, make sure it is in alignment with your life goals. If it’s not, it’s time to look at other strategies.
Life Stage
Leveraging debt can be a very good strategy in the wealth building stage. It enables you to borrow either the bank’s money, or someone else’s, while maintaining control of the asset. Tremendous wealth can be built in a shorter amount of time.
There’s a point in time though where leverage won’t make as much sense, especially as you are near, or reach financial independence. Reaching financial independence means you have won the money game. If you’ve already won the game, it doesn’t make a lot of sense to put your money at risk by utilizing too much leverage.
Again, leverage is a double-edged sword that comes with risk. Eventually you want to de-risk, which would also mean reducing or eliminating leverage.
Using a simple example, if you have a few rental properties with a combined monthly payment of $4,500–that is a risk to you if something goes wrong with the properties. However, if you pay the properties off or sell them, you are significantly reducing your risk.
Conclusion: Ultimately Your Decision
Think about using a chainsaw. If you know how to use it properly, it’s a great tool that can help you trim trees and difficult shrubbery in a fraction of the time. Use it improperly and it can do serious bodily and/or property damage.
Much like a chainsaw, leveraged debt is also a tool that can help or harm. Use it properly and you can make a lot of money. Use it improperly, too fast, without knowledge, or have market conditions shift–and you risk great harm.
Weigh the risks and your life circumstances, because it’s ultimately up to you if this is a tool you want to use or stay away from.
Do you leverage debt? Why or why not?
