Good and Bad Uses of Leverage
Earlier this year, I suggested starting the decade off right by paying off debt. In general, debt is something that should be eliminated. Credit card debt is expensive and often unnecessary, personal loans generally carry a cost to personal relationships as well as interest, and mortgages hang around forever and make you a renter who still must pay for maintenance rather than a true owner.
On the other hand, businesses use debt strategically even when they have cash available, so why can’t people? Well, businesses, if operated well, often have teams of well-paid financial analysts who know how to determine whether assuming debt will likely be a profitable solution. You and I have just you and me.
Although I dislike rules of thumb, one that may help in this decision states you should go into debt only to invest in appreciating assets or assets that provide a positive cash flow. This is the crux of the good debt vs. bad debt argument. How do the most typical uses of debt stand up to this rule of thumb?
A car fails the test. The value of a vehicle decreases over time and produces a negative cash flow. You have to pay expenses like maintenance and fuel to operate the vehicle properly. One should not go into debt to buy a car unless absolutely necessary because you will certainly spend more money with a car loan that you would otherwise. A car won’t provide you with any income to cover your loan unless you’re using your car in business.
A house, however, is a tougher decision. Over long periods of time, houses appreciate at a rate similar to inflation, but they produce negative cash flows (maintenance expenses) just like a car. But many people don’t have hundreds of thousands of dollars available in cash when they buy a house, so they are willing to take on the risk of debt.
Student loans are interesting. What are you buying when you pay tuition? Certainly nothing you can photograph like you do when you document your household inventory. Education builds an income-generating asset: your mind and its ability to think and do. An education will help you increase your cash flow because you’ll be qualified for better jobs and you’ll likely earn more money. That qualifies as an appreciating asset, so under this rule of thumb, going into debt for an education could be worthwhile.
Buying a house and renting it out might be a good candidate for borrowing. By making some assumptions about how much you expect to earn from rent and how much you expect to pay for maintenance expenses, you can use the Net Present Value formula in Excel to determine whether you should proceed with the purchase and what kind of financing you should accept.
Savvy investors use leverage to increase their returns in the stock market. By using borrowed money to buy stocks, traders count on the stock’s value increasing so they can pay back the lender with the proceeds and keep the rest. The problem with trading on margin like this is that if the value of the stock decreases, you will have to pay pack the loan with your own money.
In the best case scenario, leverage is used when the returns from the investment cover more than the cost of debt in the form of interest to be paid. This ensures you’re making money on your investment above the ability to pay back the loan. Leverage gone wrong can destroy your finances, take down a business, or collapse an economy.
Lexically related: If you haven’t already, take a look at the television show Leverage on TNT. It has nothing to do with finance, but it is well-written.
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There is an important difference between using leverage for a business enterprise and using it in your personal life. In a business enterprise, the object is to increase your wealth. For a business enterprise, leverage has two purposes: to provide funding to make it possible for you to pursue the business, and to increase the return on equity. Buying a house and renting it out uses leverage for both those purposes, whereas using leverage to increase your returns in stock investing uses it only for the latter.
Using leverage in your personal life, with the exception of student loans, does not increase your wealth, it decreases it. There may be reasons to use it – most people couldn’t buy a home without some debt – but it’s best thought of in those circumstances as a necessary evil.
I see a few holes in your logic.
With the car, you say “don’t finance it because it loses its value.” But a car has utility, and the utility of the car may very well be worth the finance charges + depreciation cost. I financed my first car (and ten years later still drive it) and have no regrets. On my $10k car, I think my finance charges amounted to $1500 or so.
With the house, your opening argument is that “it holds its value over time.” But that’s not really a compelling reason — you’re still paying finance charges on the money you borrowed. The real question is the utility — since you’d presumably have to pay rent somewhere else, the question becomes, “Are the interest, taxes, and maintenance expenses worth not having to pay rent?” But your argument slips to “but most people don’t have that kind of cash, so they just borrow it.” Well, are you saying borrowing money for a house is a good thing because everybody does it?
Paying interest clearly only makes sense when obtaining the item leaves you better off than you were before.
The problem with that reasoning is that when you purchase a car/house or even lease/rent, there is an utility to the purchase that doesn’t make it a good investment per se, but makes it a good decision regardless. Most people would be vastly better off if they stopped thinking about the investment value of their homes and realized that they live inside it. If you plan on selling it or replacing it within five years then it’s important to think strategically, but for most people, that shouldn’t be the target goal to begin with.
Yale professors Ian Ayres and Barry Nalebuff just came out with a book that says young investors should borrow money to invest in the stock market. They took historical market returns and determined that an investor in his 20s would reduce his risk by 20% and increase his portfolio at retirement by 60% by using 2-to-1 leverage. You should check out the book…I think it’s called Lifecycle Investing. IMHO, it’s too risky. A kid who used 2-to-1 leverage before the market dropped 50% would have lost all his money.