Financial Leverage: Is it the Missing Piece of Your Financial Plan?
Could leveraging your assets to earn even more money be the key to wealth?
“In order to get what you want, one has only to apply the proper amount of leverage.” Have you ever heard that before? Usually someone is referring to squeezing information out of someone else. But there are many different kinds of leverage.
Financial leverage can be defined as using existing assets to obtain access to a larger amount of money for the purposes of making more money. Think: gaining investors to start a business, or “leveraging” capital to grow an existing business.
Simply put, leverage is borrowing money and using something you already own as collateral.
Collateral: something pledged as security for repayment of a loan, to be forfeited in the event of a default.
And though leverage may seem to make sense in some situations, it is still debt. And all debt carries risk.
I’m sure you already know how I feel about debt, but since leverage is such a widely used concept, I think it’s worthwhile to discuss it. So let’s explore the concept of leverage, and also the risks involved.
The Original Form of Leverage
The word leverage comes from another word: lever. And leverage basically means: the act of using a lever. So what is a lever? And how can we use it?
Archimedes once famously said: “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”
If you’re not familiar with the terms fulcrum and lever, don’t worry. They’re physics terms. Let me see if I can illustrate them for you along with leverage in the sense with which Archimedes was referring.
Imagine you had a seesaw. And one side of the seesaw was much longer than the other. It probably wouldn’t be much fun as a seesaw. But both sides of the seesaw together would be your lever.
And the point where the unbalanced seesaw is attached to the ground is the fulcrum.
If your, . . . uhm . . . “bigger” friend sat on the short side of the seesaw, you could very easily raise them into the air by simply pressing down on the other, longer side.
The further away from yourself you can place the fulcrum, the less effort you need to exert to lift your friend. In other words, the greater the difference in length of one side compared to other of the seesaw, the easier it is to lift your friend into the air.
Leverage can be used in a variety of ways. A medieval catapult is a great example of leverage. As is a trebuchet. Jacking up your car with a jack in order to change the oil is another form of leverage.
In these cases, leverage is a useful tool to move or accomplish a task that would be almost impossible otherwise. Can you imagine the crusaders trying to throw large rocks in order to bring down a castle instead of using leverage in the form of catapults? Or would you have your son stand next to your car and attempt to lift it up while you shimmy underneath to change the oil? Of course not! Leverage makes sense in these situations.
But Back to Financial Leverage
The most common type of financial leverage that I hear most consumers applying involves their house and mortgage. They would rather keep their mortgage, and instead of paying it off early, invest the difference in the stock market.
In theory, the numbers may make sense. Because you can earn on average 10% per year investing in market index funds. And since most mortgages have interest rates under 5% or even under 3% depending on when the loan was originated, you can earn more on your extra money by investing.
For instance, if you had a mortgage paying 3% interest, you could in theory make a 7% profit on your money. You will lose 3% in mortgage interest, but you gain 10% in the market. The difference, or “spread”, is what these consumers are chasing. And you can also deduct mortgage interest from your taxes making the “spread” even higher.
Is this really a wise move? Should this be a part of your financial plan?
I don’t think so.
Think of it this way. If your house was paid for free and clear, would you go take out a mortgage and invest all that money in the stock market? Would you risk your house to invest? If you prioritize investing over debt repayments, this is essentially what you’re doing.
I think most of us would not knowingly risk our primary residence just to earn a few extra dollars each year. But we’ve been duped by the banks and other financial advisors. They advise that you keep your mortgage around because it’s “good debt”. And invest with them instead.
Keep it simple, stupid!! Don’t risk your house on a few extra percent.
Does leverage make sense in any financial situations?
When it comes to using leverage, you must always use something you already own as collateral. For most consumers, as we discussed above, the most valuable asset they have is the equity in their primary residence. It is not wise to risk your house as collateral.
But if you have other assets, you may be willing to use them as collateral in order to secure funding for a startup business for example. This of course is up to you. Just be careful how you structure the business so that if something goes bad, the bank can’t take your house.
For some, the allure and reward of owning their own business may outweigh the risks of using leverage.
In my opinion, the only way financial leverage makes sense is under the following conditions.
- You don’t need the collateral to live or survive.
- The investment will earn or has the potential to earn you many times more than your initial debt load. Meaning you can quickly disperse the debt once the investment takes off.
- You have a valid escape plan if the investment goes south which doesn’t involve more debt or risking your necessary-to-survival assets.
These conditions rule out leveraging your primary residence to invest. They also eliminate investing in the market with your leveraged funds. You won’t be able to meet condition number two by investing in the stock market unless you’re trying to pick unicorns.
So what do you think? Is leverage a smart move? Would you risk your house to invest in the market?
Let me know what you think by leaving me a comment below. Thanks as always for reading and sharing.