Today we are going to talk about the best ways to use debt to your advantage. Now debt can be a scary buzz word to people, particularly if yourself or a family member have tangled with what’s termed “Bad Debt” before. Credit cards, payday advances and other hard money loans can wreck havoc on your savings plans.
Like many things though not all debt is created equally. While too much debt can be like an anchor around your neck other forms can be used to springboard your financial future. This is where leverage comes into play.
Are you Leveraging your Debt as a Tool For Growth?
While paying down debt is always a laudable goal, what often happens is people become hyper focused on that ideal. They may be missing out on an employer match or significant long term tax and asset benefits of retirement accounts to pay down extremely low interest rate debts. Those folks often are making a mistake, while not a fiscal breaking one, a mistake all the same. The opposing situation is somehow holding onto credit card debt with hefty interest rates north of 20%.
Most often though people fall somewhere between these extremes. The question then arises do I pay down my debt or invest in taxable accounts? There is no one size fits all answer to this question, but I have strived to put together a template priority list for people to work around given their individual cirumstances.
- Get any available employer match
- Pay off high interest rate (8%+) debt
- Max out available retirement accounts
- Invest in assets with high expected returns
- Pay off moderate interest rate (4-7%) debt
- Invest in assets with moderated expected returns
- Pay off low Interest rate (<4%) debt
- Invest in assets with low expected returns
We will primarily be discussing debts on lower side of this list, as <5% (or lower depending on risk tolerance) is where leverage can truly begin to jump start your financial journey.
Leverage Mortgages in Real Estate
The most common form of leveraged debt that many will encounter through their lives is in the form of mortgages, either on their primary residence or in an investment property. Let’s focus on investment properties for the moment, although house hacking a home is a supercharged form of leverage.
Now when looking at properties these can be leveraged anywhere from 100% ($0 down) to 0% (Paid full in cash), most typically an investor will find their loan provider will require at minimum loan to value (LTV) of something like 75%. So let’s set up some parameters and see how leverage plays an effect over 30 years:
- Home Value – $250,000
- Down Payment (25%) – $62,500
- Loan Amount – $187,500
- Mortgage Interest Rate – 4.5%
- Mortgage Terms – 30 Years
- PITI – $1,300
On average real estate appreciates at ~3%/year so year 1 we can assume equity growth of $7,500. We can also safely assume after expenses (Maintenance, property manager etc.) that our total income in rent is $1,600, which over a year equates to $3,600. For simplicity sake we are going to ignore mortgage pay down, depreciation and the compounding effects of equity and rent appreciation, which only improves these returns.
- ($7,500+$3,600)/$65,000 = 17% return
So in the situation above we are making a 17% return and our interest is fully offset by the rental income on the property. A pretty good utility of leverage right? Of course leverage swings both ways. If a market downturn occurred and the property lost 25% of value our equity is completely wiped over that duration.
While I am a strong proponent of intelligently applied leverage in finance a careful investor uses it to juice their returns, but avoids getting greedy. I have yet to meet someone who went bankrupt by being debt free.
Using Leverage in Business Loans
Another common application of leveraged debts is for small businesses looking to grow. Whether in the start up phase or expansion leveraging assets can exponentially grow a company’s revenue. A small retailer wants to expand into an available space next door in a strip mall. In addition to increased rent, the business will have to buy fixtures, shelves, tables, and other operational necessities. It will also mayrequire additional inventory.
Most small businesses don’t have sufficient cash on hand to cover all these expenditures, so the retailer applies for a business loan. This loan is leverage. It allows the business to do what it couldn’t do without the additional funds.
Leverage in Stock Markets
The same principals can be applied to other aspects of your personal life, the stock market for example. I am fairly risk adverse in stocks so I would strongly recommend caution with leverage (Margin Accounts) in the stock market. That said it bears reviewing so you understand one of the more dangerous aspects of leverage.
The majority of brokers allow individuals to create what are called margin accounts. These accounts essentially act as loans to buy additional stocks, most often used by day traders. The issue when looking at these accounts is the interest rates are variable, the LTV maximum is 50% and most importantly the loans are callable. What that means if the stock suddenly plunges the broker can choose to sell at any point essentially locking in any losses that were sustained.
If you choose to pursue margin accounts make sure you do so with caution. Review your brokers risk tolerance, understand the stocks you choose to invest in and do not overleverage yourself.
When to Take Advantage of Leverage in your Life?
I am a proponent of leverage in personal finance. A deliberate, well executed plan, with the right leverage can jumpstart your path to financial independence and allow portfolio growth not possible otherwise. That being said I believe in deleveraging yourself as you start approaching retirement and more importantly to avoid over enthusiastic leveraging.
The common consensus among professionals is that a debt to asset ratio should be no higher then 35%. Lets look at a few examples.
Scenario #1 – Reasonable Leverage Risk (Early Career)
A young attorney is employed at a stable firm bringing in $200,000 annually from their work. They recently graduated school and have $50,000 in remaining student loan debt at 3% with $25,000 saved over the year. They just recently closed on a $300,000 home at 4%. This would put their debt ratio at ($300,000+$50,000)/($300,000+$25,000)= 107%, but you would be hard pressed to argue this individual is overleveraged.
With a stable well paying career, low interest rate loans and a long potential work span ahead there is nothing wrong with them putting savings into taxable investment accounts & additional real estate instead of directing that towards their debt. While putting extra funds towards debt if risk adverse is reasonable, the additional leverage risk to get to retirement a bit earlier is perfectly acceptable.
Scenario #2 – Decrease Risk (Early Career)
You have recently started a new sales job, it is primarily commission-based role. It is within a very cyclic industry and while you can bring in as much as $20,000 some months you only make $1,000 others. You have an outstanding credit card balance $40,000 @ an average of 18%. Some of your friends are making a killing with margin accounts and you are thinking of trying with your excess funds.
It should be obvious, but this is a no across the board. The high interest credit card debts need to be paid down prior to any other actions, whether it be through a refinance or slowly chipping away at the balance. In addition margin accounts are a risky way to leverage your money and this individual is working in a less then stable job. A reserve fund needs to be established and high interest debts need to be fully eliminated before any though should go towards expanding their debt to asset ratio.
Scenario #3 – Reasonable Leverage Risk (Mid Career)
You run a well established consulting business that has been in the industry for 15 years and have been cash flow positive annually the last 10 years. You are evaluating on expanding to a larger office, bringing on additional staff and increasing your advertising budget, but will need $200,000 to cover all the expected expenses. The business currently has a portfolio of $750,000 in assets broadly diversified across several asset classes. You approach a bank who offers a business loan to cover the full amount at 5%.
There is minimal risk involved in this deal and the leverage provided by the loan will help you expand your business rapidly. While there is always risk you have a proven track record in the industry and have shown stable profits for an extended duration. In addition you have more then enough in other assets cover the needed amount with a debt to asset ratio of ~25%. Take advantage of the relatively low interest loan to help accelerate the business growth.
Scenario #4 – Consider Decreasing Risk (Mid-Late Career)
An engineer in their late 40’s has been a diligent saver through their career and has a nest egg of $2,000,000 and currently making $150,000/year. They have a $250,000 remaining mortgage @ 5% on a $500,000 house and just received a inheritance from a deceased family member. Their ratio of debt to assets is only 10%.
Now some leverage enthusiasts would argue that she is underleveraged and she should utilize the inheritance as capital to buy investment properties and expand her leveraged portfolio. I would argue she should actually deleverage further and use the inheritance to pay down her mortgage further. Let’s say she makes 8% annually on that $250,000, while paying 5% interest on the debt. 3%*$250,000=$7,500. $7,500/$2,500,000=0.3%.
That $7,500 while by the book is better is just so minuscule in their life. It simply won’t move the needle at 0.3% and won’t be noticed at all. Comparatively paying off the mortgage and removing monthly payments can have sizeable mental benefits.
Leverage Works
Debt, particularly well planned and invested debt can have lasting and tangible benefits on someone’s life. If executed well it allows someone to reach financial freedom much sooner then otherwise possible. That said it needs to be used cautiously and intelligently to avoid becoming underwater.
If you are interested in leverage and want to hear opinions other then mine I would strongly recommend a book series called The Value of Debt for a pro leverage opinion or for a more anti-debt opinion Dave Ramsey pieces.
