What Is Leverage?
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Why Use Leverage?
When an investor uses leverage, they are able to wield much greater financial buying power than if they relied on their own limited capital. Leverage is useful for providing a shorter path to wealth creation. It is so-called because it “leverages” other people’s money (in the form of debt) to obtain assets and investments that can produce higher returns than would be possible with the investor’s own capital.
Since every investor needs money to make money, the capital available to an investor or a company to grow their wealth production naturally gains a return proportionate to the amount of capital they invested. However, when investors have adequate financial leverage and can borrow money, they will not need to rely on their own cash to acquire assets that can produce larger returns.
Investors and organizations use leverage in different ways. For example, companies use debt financing to fund business operations and acquire new assets (instead of selling equity in the company to raise capital). Granted, debt financing still requires collateral; for example, the borrowing company can use the business or its assets as security for the loan.
However, there is always downside risk to any investment strategy. Leverage can compound the borrower’s losses in the same way it can multiply gains. In short, the more leverage a company or investor takes on, the higher their chances of financial loss when things do not go according to plan.
Borrowed capital does not have to come from a financial institution to be considered leverage. Private loans or private money, where the funds come from personal connections, can also be a form of leverage.
Leverage in Real Estate
A typical example of leverage in real estate is a mortgage.
In traditional house purchases, the lender and the buyer split the bill (ideally, an 80-20 split, respectively). In this scenario, the 80% is the leverage. In some cases, such as a zero-down financing, the leverage might go as high as 100%.
Cash-out refinancing constitutes leverage as well. Like HELOCs and HELs mentioned above, cash-out refinancing involves turning a portion of home equity into cash while getting an entirely new mortgage with fresh terms. The borrower can use the proceeds from this transaction to spruce up the house and increase its value or get some exposure to other assets for diversification.
Using Leverage as a Real Estate Investment Strategy
Real estate investors take leverage to a whole new level. They acquire debt through business lines of credit to finance their property purchases.
Robert Kiyosaki and Grant Cardone are excellent examples.
These successful investors have been borrowing funds to build their real estate portfolios for decades without touching their cash reserves or selling assets.
Thanks to dozens of leveraged properties under their care, Kiyosaki and Cardone have been able to amass staggering wealth, earn tremendous passive income, and exponentially grow their net worth.
Is There Such a Thing as Too Much Leverage?
A borrower can become overleveraged when their debt service exceeds the amount of cash flow available to cover each month’s payment. Another measure of being overleveraged is when a creditor is unwilling to extend additional financing the borrower needs to continue operating or growing their business.
It can be difficult to determine when leverage crosses dangerous territory. Lenders tolerate risk differently, and borrowers can overestimate their ability to handle their finances.
However, portfolio lenders pay little attention to Fannie Mae and Freddie Mac rules since they keep mortgages on their books. They can come up with their own standards to protect their best interests or adopt the rules from government-sponsored enterprises as they see fit.
Then again, just because one has the credentials to borrow a certain amount of money to acquire an asset does not mean one should. A person with a six-digit salary could be one tragedy away from financial ruin. A good case in point is the severe homelessness in Santa Clara County, which has a median household income of $124,055.
Being overleveraged does not necessarily mean the business is failing. However, it does mean the borrower will be unable to continue borrowing until they build up a stronger equity position on their balance sheet.
Is Leveraging a Good Idea?
Leverage is neither good nor bad. It is merely a tool to accomplish an end.
While debt is not inherently desirable by itself, it can also present significant opportunities to grow. These opportunities simply would not be possible without taking on debt to finance an expansion. The only other option would be to wait much longer to make a move, and this also consumes an even more precious resource: time.
Take the case of a mortgage. Strictly speaking, one can simply save money to afford a house; taking out a mortgage is nothing more than an option.
However, on average, it takes 51 months for an American household to set aside roughly $55,000 to put down 20% when buying a single-family property. This time is doubled if the household is in Hawaii.
On the other hand, abusing leverage can have long-term and far-reaching consequences.
For instance, it took years for the victims of the 2008 housing crisis to recover. The Great Recession has shaped the psyche of millennials, causing them to be mindful of their discretionary spending, delay milestone purchases, and be more financially self-sufficient.
- Leverage is when one borrows capital to buy income-producing assets that would otherwise be harder or take longer to acquire with the investor’s own capital.
- Investors use leverage to increase their purchasing power multiple times to maximize their gains.
- Leverage can be financially devastating when abused, but it enables one to build more wealth in less time successfully when applied properly.
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