Financial Leverage

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?

Defining leverage

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

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.

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17 comments

  • Leverage is a very dangerous game to play. It led to the tech bubble and crash and it led to the housing bubble and crash. I say no thank you to leverage.

  • I’m too risk averse to play the leverage game to any great extent, with real estate. One’s own home is enough! In periods of declining prices, it’s easy to lose entire investments! In another time period, as in a few years back, there were people making a ton of money with leverage.

  • Leverage depends on tolerance for risk. I like a little of both. I like the house for 100k but I like to gamble. It’s all about what your personality is like.

  • I’m not that much of a risk taker to play the leverage game. You also have to be willing to walk away if need be.

    • Sometimes I think people get themselves into leveraged situations and *wish* they could walk away, but then find out that they can’t really do that — at least not easily.

  • Dan

    Leverage is how someone with little money can become someone with big money. I think you have to have the personality to basically “go for it”. That’s the type of person who can go broke go bankrupt and go for it again. Not having the fear of staying poor because they believe they will make it someday someway.

    • That can definitely happen using leverage, but so can the bankruptcy part. I prefer a surer, less-risky path to wealth though.

  • I love Leverage!! Too many people don’t understand “HOW” to use leverage to build wealth and get caught up in speculating. Many people still think owning a “primary” home is an asset and as such they convince themselves that they should “leverage” – bad move. Owning a primary is not an asset, it is a Doo Dad and there is nothing wrong with that, the problem is when people think they’re investing when they are just living in a home.

    On the other hand, if a rental property can generate 15%+ returns, has equity and can be financed with a 3-5% FIXED interest rate for 30 years, I think the bigger risk is watching inflation eat away your 150K.

    Just my two cents – Leverage up!!

    • You make some good points — people do often use leverage to speculate instead of as a tool with a reasonable goal. I do think owning a home is an asset, but not particularly an investment unless you’ve got plans to sell it after a period of time and it’s in an area where its value is likely to increase. Having inflation eat away at things is definitely a risk too as you point out.

      • I hear ya, having a reasonable goal -making 15% on your money via a rental w/leverage is not sexy, but will out preform most other asset classes, especially when you factor in – depreciation, tax deductions, appreciation, rent increases, etc.

        I guess my beef is with the people that are ALL or nothing. I hear so many people say debt is bad and I agree on some level, but I also think no debt (mortgage) is bad too.

        Quick example, I had a friend buy a house in cash in 2005 – 450K. Two years later he sold the same house for 280K – ouch.

        Great post and thanks for taking the time to reply.

        best,

        AG

  • I liked your story – five houses. Knew of a real life situation like that and it turned out well. Guess it depends on where the houses are located – i.e. Southern CA was in the bag.

    Personally I am a leverager, though I have become more risk averse as I get older, LOL.

    My good friend bought a four-plex fixer-upper in L.A. and rented three of the four out – they essentially paid her mortgage. She took the worst apartment of the bunch, naturally to maximize her rent income. What a plan.

    • I like your friends idea; that sounds like a good way to go about it — plus you can easily keep an eye on what your tenants may be doing to the property. And you’re right, location really can make a huge difference.

  • Leverage is how rich people get richer. Used properly, middle class folks can and do take advantage of it as well. That’s what rental real estate is all about. Small business loans, even being able to buy your own home – it’s all leverage!

    • It can absolutely be one of the ways rich people get richer, and others as well. But you can do the same thing with rental real estate just by buying low (with cash) and hanging on to it over time.