Leverage Debt

Who???!?!

Who???!?!

Debt is a four letter word in the world of personal finance.  I know it’s literally a four letter word—jeez, lay off pun police, but you know… a four letter word like one of those words.  Like poop, fart, or boob.   It’s such a bad word, many financial advisors will tell you to avoid debt all together, like you would tell a child to avoid the creepy old guy at the end of the street.  They liken debt to herpes, even though pretty much everyone has herpes, including them[1].

Affording Debt

The fact is that debt is not as simple a topic as the average financial advisor would paint it out to be.  Like anything else, there are those that can and those that can’t afford debt.  Also like anything else, the more money you have both in savings and in income the more you “can” afford debt.  This is why the wealthy tend to have more debt, in real dollar terms, than the proletariats.  A recent study by International Monetary Fund found that today the wealthy have $.85 of debt for every dollar of income while the remaining portion of society, the bottom 95%, had roughly $1.40.  This does not contradict my point, since this is a percentage based statement.  For example, if I make $200,000 annually and my poor cousin makes $40,000, using the above percentages I would have $170,000 in debt, and he would have $56,000.  Since my debt, as a percentage of my income (and probably even less as a percentage of my savings) is far less than my cousins, I therefor am more likely to be able to afford my debt while my cousin is in need of a Invest in Your Debt program.  This is just fancy talk for saying that when it comes to debt, “it depends”.

Different Types of Debt

Another aspect that sets the wealthy apart when it comes to debt is the type of debt they have.  The wealthy are far more likely to have “leverage debt” versus “soul sucking debt”[2].  In physics, leverage is the term used to describe an increase in power, or strength, allowing for more force to be generated.  This concept is applied to business in that “leveraged debt” multiplies returns, or losses.  As a very simple example, if ponied up $10,000 of my own money and borrowed $100,000 to buy a stock I am sure will double in value, I am leveraged out $100,000 in debt that I need to pay back.  The plan, obviously, is to pay this debt down with my gains.  Low and behold, I am right and the stock doubles in value.  I sell, give the lender back their $100,000 and I keep the $110,000 gain.  Since I only had $10,000 of my own money on the line, my gain is 11X (1,000%) on this particular transaction.  Without leverage, my gain would have been a paltry 100%.  Man that would have been terrible.  However, if the stock decreased in value by 100%, my losses would have been 1000%.  This is how leverage works in business, and fundamentally differs from “soul sucking debt” in that it is tied to an investment, not a handbag.  The wealthy tend to invest their money while the non-wealthy tend to spend theirs, and often times a wealthy person’s investments are leveraged.

Leverage Debt We Can All Afford

Everyone can benefit from those smart enough to successfully utilize leveraged debt.  There are multiple business models that are founded upon the concept of leverages debt.  Two notable ones are real estate and private equity.  If you know what a mortgage is and why people need them then you know why real estate based companies use leverage—because they cannot afford a property in full or do not want to, and because they can afford the payments.  Private equity’s use of leverage debt is a bit more complicated and perhaps out of scope for this article, but the important point to recognize is that both businesses are using debt as a tool to “leverage” their investments.  We can all benefit from their leveraged gains (or join them in the poor house if they become “over-leveraged”) by investing in their companies through stock purchase, or by investing in a fund that specializes in a given industry that who’s model is primarily leveraged based.  For those with the cash flow and savings, purchasing a multiple family property would be a way to use leverage debt for financial gain[3].

Next time you hear a financial advisor shouting to the hill tops that debt is bad no matter what, throw a rock at them.  The truth is that it depends on the type of debt, and depends still on the intelligence of the plan involving leverage.  The ability to use leverage debt is usually predicated on already having a certain level of money and income, but pending on the investment that level doesn’t necessarily have to be much.

I am reluctant to simply end this article on that note.  Although it seems encouraging—and it is meant to, pointing out that leveraged debt is often accessible to the middle class but is often not utilized (at least usually not properly) while the rich are leveraging themselves to further wealth seems like an encouragement to become leveraged.  It is not.  The $1.40 of debt per dollar of income that the bottom 95% of households in America have is primarily composed of terrible forms of debt such as credit card debt or worse still, student loans.  So long as this type of debt sits on your personal balance sheet your primary financial objective should be to reduce it to a manageable level, usually below 10% of annual gross income.  I am pointing out that after you reach that level should you be of sound and educated mind, leveraged debt may be a tool you can use to further enrich yourself.  That should be motivation to pay down that soul sucking debt.

Now get on it, you boob.

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[1] And now that I have used the words “poop”, “fart” and “boob”, along with a pedophile reference and a herpes joke in a single paragraph of a finance article, think Forbs is interested in a syndication deal?.

[2] “Leverage debt” is actually not a real term, but for the purposes of our discussion it’s the term I prefer.  The true term is “financial leverage” but this is a bit misleading for the average person, I think, because it is not immediately apparent in the term that the leverage stems from debt.

[3] I personally do not consider a primary residence based mortgage a form of leverage, although in the classic sense it is.  I think this because a primary residence does not generate revenue and you use your own money to pay into the equity.  I will post as article about this in the future.

8 responses to “Leverage Debt

  1. I’m glad we hold a lot less debt than the average household, but the stuff we do have is soul sucking. Haha. I still think the biggest freedom would be saving and living completely debt free, but I understand the concept of using debt to build wealth. I’m so not a risk taker, though. I accept it and accept that I will probably never be in the top 5% because of my apprehensions.

    • It is definitely not for everyone, however if you find yourself with an opportunity that may require a little “good debt” in order to make a lot of money, or create easy passive income (in excess of the debt: income pays the bank and you) I would encourage you to seriously consider it.

      I don’t think leverage debt is necessarily only for the top 5% of households. I think it is something that can help secure a middle class family (and commonly does) and create a large annuity for retirement.

      Given all that you write about and discuss one your site–and people, she runs a great site be sure to check it out– I think you can handle a little leverage debt no problem. You got this thing in the bag.

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