Leverage is one of the most powerful strategies to use when investing. When used correctly, leverage can improve your buying power and help you seek greater financial gains. But when used incorrectly, leverage has the potential to ruin you.
How do you know when you are over-indebted? And is there really a definitive answer to this question?
WHAT IS FINANCIAL LEVERAGE?
Leverage basically means investing with borrowed funds in order to increase your purchasing power.
The most common and easiest way to illustrate this is buying a house. Most people don’t have $300,000 in cash to spend on a new home, but maybe they could put down $30,000 for a loan. With the right loan provider, they can borrow the remaining $270,000, buying a $300,000 home with only $30,000 of cash on hand.
Of course, leverage is not exclusive to real estate. You can use financial leverage in trading, private equity, and dozens of other applications.
Leverage is powerful for several reasons. First, you will have a wider range of investment opportunities. Instead of being limited only by the amount of money you have, you are limited by the amount of debt you can take on.
Second, you’ll have faster access to fast-growing assets. Instead of waiting 10 years to buy a property, you can buy that property today and benefit from its appreciation.
Third, you will benefit more from continued appreciation. If house prices increase by 10%, the value of $30,000 will only increase by $3,000, while your $300,000 house will increase by $30,000. Since you only need $30,000 in initial buying power in both scenarios, clearly the latter scenario is more favorable.
WHY OVER-INDEBTEDNESS IS A BAD THING
Leverage is not always a good thing. In fact, it can devastate you if you’re not careful. There are two major risks to consider when it comes to leverage.
First, you need to think about your ability to repay the debt. In most applications, you will be responsible for making regular payments to your financing provider.
In the case of a mortgage, you may be able to borrow $270,000 initially, but you will need to start paying off that debt on a monthly basis. Given a reasonable interest rate and adding property taxes, insurance and other fees, that could be a payment of $1,800 or more per month. If you are unable to make this payment, the bank may be able to seize your property or impose liens on your other property. With just one property, it’s not hard for most people to keep up, but if you take out multiple mortgages, it’s increasingly difficult to keep up.
Second, you are increasingly vulnerable to sudden price drops in your chosen market. If the housing market drops 10%, your $30,000 home will lose $3,000 in value and you will still owe your outstanding principal of $270,000. This is the number of people who end up “under water” on their mortgage. They end up owing the bank more than the house is worth.
Additionally, you will need to think about the cost of leverage. Borrowing money is (almost) never free. Residential mortgages and other types of debt can cause you to rack up interest payments and other charges quickly.
ARE YOU IN OVER-INDEBTEDNESS?
Being over-indebted means you are disproportionately vulnerable to threats. There is no dollar amount that constitutes over-indebtedness, as different people in different situations will have different consideration factors. Either way, you should think about:
• Total assets: How much total assets do you have? If you have enough liquid capital to repay all your debts in full, it is difficult (but not impossible) to prove that you have adequate leverage. If prices fall or you fall behind in your payments, you can liquidate some of your assets to fill the gap without major consequences.
• Total debts: How much total debt do you have? It shouldn’t upset you to think about how much money you owe other people. The more debt you take on, the more likely you are to go into over-indebtedness.
• Portfolio diversification: We all know portfolio diversification is important, but it’s even more so if you’re leveraged. If all of your debt is associated with a single sector of the economy, such as real estate, you will be particularly vulnerable to price crashes or volatility. If you spread your leverage across multiple asset classes and industries, you run less risk of over-indebtedness.
• Cash (and reliability): Most people use financial leverage in the pursuit of positive cash flow, using the financing to purchase properties, businesses, or other assets that provide ongoing returns. Some assets have stronger and more reliable returns than others. If you find yourself in a disproportionately unreliable cash flow situation, you run a higher risk of becoming over-indebted.
• Market volatility: The risk associated with leverage is often linked to the volatility of the asset in question. Assets that are more stable and more fundamental tend to carry lower risks of over-indebtedness. If you suspect an increase in market volatility in the future, or if you are in a particularly volatile market, you should be more careful with the leverage you take.
• Individual risk tolerance: Of course, you also need to think about your risk tolerance as an individual. Some people are naturally more cautious investors, while others are more risk tolerant. In general, the older you get, the less risk tolerance you have. But that’s a variable you can decide for yourself. How much are you really willing to lose?
The question of leverage and over-indebtedness is not a simple one to answer, as there are so many variables at play. However, with proper evaluation and careful consideration, you should be able to quickly determine if you are about to get into over-indebtedness of yourself (or your business).
Ty Foster is Managing Director at Invest.net. An experienced investment professional, Ty resides in Salt Lake City, UT.