Why is it called “life insurance” when it is, in fact, insurance against untimely death? The words we use to frame a concept or an argument can have tremendous appeal.
In the same way, the idea of using someone else’s money to make a purchase or investment can be thought of as debt (negative) or as leverage (positive). The way it’s framed can shift our thinking.
So, is taking out a loan good or bad?
I understand the appeal to simplify things. There is so much information out there, especially concerning money, that we feel the need to categorize everything to make it easier for us to evaluate our options. Instead of a balance sheet of assets and liabilities, we want a balance sheet of good and bad. By doing so, we can easily assess how a financial product, concept, or idea fits within our worldview.
What is leverage?
Debt is easy to define. It’s an amount of money borrowed with the promise of being paid back in the future, usually with interest.
Leverage is a concept borrowed from mechanical engineering. A lever is a simple machine that takes an input force and amplifies it to an even greater output force (think of a pair of pliers). This act of providing leverage is applicable in finance, too.
While leverage is debt, the concept of leverage is using a relatively small amount of your own money (input) and amplifying it to provide an even greater output.
There is no hard-and-fast rule of what debt is leverage. You could argue buying something with a credit card is leverage. But I think a wise way to define leverage is:
- When buying an appreciating asset
- When the opportunity cost for cash is high
How to wisely use leverage
When buying an appreciating asset
A rule-of-thumb states that anytime you buy an appreciating asset with leverage, you will get a higher rate of return. If you buy a $400,000 house with cash and the house increases by $80,000, you will realize a 20% return. If you used a mortgage to buy the house with an $80,000 down payment, you will realize a 100% return on your initial investment, minus any costs of obtaining and servicing the loan.
Most people aren’t real estate investors and are buying houses with the intent of living in them. In this case, leverage is still smart because many cannot save up enough to buy a house with cash. For example, the median listing home price in my town is $550,000 as of December 2021. How long would it take for you to save up half a million dollars?
By using leverage, you are using a relatively small amount today and amplifying it to purchase a much larger asset. The best part about using leverage to buy a house is that houses are appreciating assets! Even though you might not think of your house as an “investment,” you are highly likely to sell your house and move in the future. If this happens, most people are happy with the return that they got on their “investment!”
Of course, current market conditions also dictate whether using leverage is attractive or not. At the time of writing, interest rates are historically low while inflation is running above average. This anomaly makes 30-year mortgages especially attractive, as you are maximizing dollars today and paying back the loan with fixed payments using dollars that are worth far less.
When the opportunity cost for cash is high
Opportunity cost is the loss of a potential gain that is missed out when choosing one option over another.
One example is keeping a lot of cash in your bank account. Since you’re not getting a return, the opportunity cost of keeping money there is high because you are losing out on a potential gain of investing it elsewhere.
In the same way, leverage can be used wisely when the opportunity cost for getting cash is high.
For example, you have $500,000 invested in your brokerage account and are looking for ways to get $250,000 for business purposes. One option is to sell securities in your brokerage account and withdraw $250,000. A second option is to obtain a loan for $250,000 using the securities in your brokerage account as collateral.
In these examples, the first option has a high opportunity cost compared with the second option. Since you are withdrawing funds, you now have $250,000 that is no longer invested and no longer earning a return or participating in compounding growth. Over time, the opportunity cost is likely hundreds of thousands of dollars in lost earnings.
The second option allows you to keep funds invested that would otherwise be withdrawn and spent. Yes, there is a cost to a loan—interest is owed, and the monthly cost of the loan determines whether it’s right for you. But for some, a collateralized loan is a great option to get funds without interrupting their long-term investment plan.
Is a cash-out refinance a good idea?
But what about a cash-out mortgage refinance? Would this qualify as a way to wisely use leverage?
Say you aren’t planning to invest the funds, but rather spend it on a home remodel. Since you don’t have funds in a brokerage account that could otherwise be used, you are looking at saving $50,000 or taking $50,000 out of your home’s equity.
There would still be an opportunity cost associated with saving up and paying cash for the remodel. The cost is that you are saving up monthly cash flow instead of investing it elsewhere and earning a return.
If saving up $50,000 requires you to direct most or all your savings that would otherwise go to your long-term investing or retirement accounts, the opportunity cost can be high since it costs you the ability to participate in compounding growth at an earlier point in time.
The dangers of leverage
Just because leverage can be good doesn’t mean it’s always wise. Here are examples of when leverage isn’t the best option:
- Too much leverage. A lot of people got burned in the real estate crash of 2007-2009 because of over leveraging. It’s wise to consider the worst-case scenarios if you are employing leverage.
- Buying stocks on margin. Unlike a collateralized loan, a margin loan is a way to get a loan from your broker to buy more securities. These aren’t suitable for most people. If the value of your account decreases below a certain level, be prepared for a “margin call” where you need to deposit more cash.
- Levered ETF’s. Double and triple-levered ETF’s are ways to get double or triple the daily movement of a stock index. Again, these aren’t suitable for most people and are designed for sophisticated traders.
Use leverage wisely
Some people view debt as something to be avoided or paid off quickly. If that’s you—that’s fine. There is no “right” or “wrong” way to manage your money.
There are, however, more efficient ways to manage funds. Leverage is simply one tool that can be used to make your resources more effective.