Leverage is something that you often hear when talking about two topics in particular: real estate investing and whether or not to pay off debt. But what does it mean, and is it a good idea?
Let’s start with a definition of what it means. The term leverage has its roots in the word lever, and works much the same way. At its most basic, a lever is a bar balanced against a point that lets you move things with less effort than it would otherwise require.
Think of it like a teeter totter (which actually is a lever). Unless you’re a super-strong athlete in Cirque du Soleil or something, you can’t pick up another adult and lift them several feet above your head. But get yourself and the other person on a teeter totter, and you can easily do exactly that just by sitting down.
Financial leverage works the same way. You apply a little bit of money to something, and are able to do much more with that money than you otherwise could.
For example, suppose you want to invest in rental property. You have $150,000 in cash to work with, and houses in your neighborhood are selling for $100,000 each. If you’re debt- and risk-adverse like I am, you would buy one house for $100,000 in cash, and have $50K leftover to use for something else or to save toward a second house. (And that’s exactly what I plan to do someday.)
On the other hand, if you have excellent credit and want to buy as much rental property as you can, you’d use leverage instead. You’d use your money to make $30,000 down payments on five different houses, and then borrow the difference for each one at a higher interest rate than you would pay to buy a house that you intended to live in yourself (typically about 1% higher).
In the first scenario, you’d owe nothing (and in fact have money leftover) and own one rental property free and clear. Except for maintenance and insurance costs, all of your rental income would be profit. You wouldn’t have any monthly payments to make, and so could put your profit toward saving for the next rental property (or anything else).
In the second scenario, you’d owe $350,000 + interest and have five rental properties that you’d be making monthly payments on. Unless rents are sky-high in your area, it’s likely that almost none of your rental income would be profit. And each time a house was vacant, you’d have to come up with the monthly payment yourself. On the plus side though, other people (your renters) would be helping to buy you those houses — and you’d have five properties instead of just one.
Is using leverage right for you?
For the most part, the advantages and disadvantages of using leverage come down to your tolerance for risk. You can do more right away using it, but you’re also immediately on the hook for more — which means you can lose more if things go south. And it costs you money to borrow money, so you should take that into account in figuring out what you want to do.
Using the example above, if you bought the five houses using cash, it’d cost you $500,000. But if you bought them using debt (at say, 4% interest over 30 years) it’d cost you approximately $789K, plus your initial $150K in down payments, for a total of $939K. Basically, you pay a lot more in order to have the use of something immediately instead of waiting until you have the money. And you’re making a bet — a bet that you will end up making more in the long run than it will cost you. (Again, you’d have to compare that to how much you could potentially make if you did not use leverage.) In both cases, it would be a guess.
Personally, I am not a fan of taking needless risks when it comes to investing (and many other things!). I thought I was once, but learned that lesson when I realized just how quickly things could go wrong with the rental property I briefly had in Texas. And I felt a whole lot better when that sold. If you have a lot of spare cash and can afford to cover your debts for a very long period of time if things go wrong — or are just fine with potentially going bankrupt — you may be perfectly comfortable with using financial leverage to possibly get to where you want to be faster.
Of course, there’s the middle ground too. It’s not necessarily and all-or-nothing proposition, although it is often framed that way. The point is investigate your options and truly understand the risks you may be taking before making a decision.