One of the most powerful strategies to utilize in investing is leverage. When used properly, leverage can improve your purchasing power and help you seek greater financial gains. But when used improperly, leverage has the potential to ruin you.
How do you know when you’re overleveraged? And is there truly a definitive answer to this question?
WHAT IS FINANCIAL LEVERAGE?
Financial leverage essentially means investing with borrowed funds as a way to increase your purchasing power.
The most common and easiest way to illustrate this is purchasing a house. Most people don’t have $300,000 cash to spend on a new house, but they might be able to put together a $30,000 down payment for a loan. With the right loan provider, they can borrow the other $270,000, thus purchasing a $300,000 house with only $30,000 of available cash.
Of course, leverage isn’t exclusive to real estate. You can use financial leverage in trading, private equity, and dozens of other applications.
Leverage is powerful for several reasons. First, you’ll have a wider range of opportunities for investments. Instead of being limited only by the amount of cash you have, you’re limited by the amount of debt you can take on.
Second, you’ll get earlier access to fast-growing assets. Instead of waiting 10 years to buy a piece of property, you can buy that property today and benefit from its appreciation.
Third, you stand to benefit more from ongoing appreciation. If housing prices rise by 10%, $30,000 will only rise in value by $3,000, while your $300,000 house will increase in value by $30,000. Given that you only need $30,000 in initial purchasing power in both scenarios, it’s clear that the latter scenario is more favorable.
WHY BEING OVERLEVERAGED IS A BAD THING
Leverage isn’t always a good thing. In fact, it can devastate you if you’re not careful. There are two major risks to consider when it comes to leverage.
First, you need to think about your ability to repay the debt. In most applications, you’ll be responsible for making regular payments to your financing provider.
In the case of a home mortgage, you may be able to borrow $270,000 initially, but you’ll need to start repaying that debt on a monthly basis. Given a reasonable interest rate and the addition of property taxes, insurance, and other fees, that might amount to a payment of $1,800 or more per month. If you aren’t able to make this payment, the bank may be able to seize your property—or impose liens on your other property. With one property, it’s not hard for most people to keep up, but if you take on multiple mortgages, it’s harder and harder to keep up.
Second, you’re increasingly vulnerable to sudden price drops in your chosen market. If the housing market plunges by 10%, your $30,000 house will lose $3,000 in value—and you’ll still owe your outstanding principal of $270,000. This is how many people end up “underwater” on their mortgage. They end up owing the bank more than the house is worth.
Additionally, you’ll need to think about the cost of leverage. Borrowing money is (almost) never free. Home mortgages and other types of debt can cause you to rack up interest payments and other fees quickly.
ARE YOU OVERLEVERAGED?
Being overleveraged means you’re disproportionately vulnerable to threats. There’s no dollar amount that constitutes being overleveraged, since different people in different situations are going to have different considering factors. No matter what, you should be thinking about:
• Total assets: How much do you have in total assets? If you have enough liquid capital to pay off all your debts in full, it’s difficult (but not impossible) to make the case you are appropriately leveraged. If prices fall or if you fall behind on payments, you can liquidate some of your assets to close the gap without major ramifications.
• Total debts: How much total debt do you have? It shouldn’t turn your stomach to think about how much money you owe other people. The more debt you take on, the more susceptible to overleverage you’ll be.
• Portfolio diversification: We all know portfolio diversification is important, but it’s even more important if you’re exercising financial leverage. If all your debts are associated with only one sector of the economy, like real estate, you’ll be especially vulnerable to collapsing prices or volatility. If you spread your leverage across multiple asset classes and industries, you’re at lower risk for being overleveraged.
• Cash flow (and reliability): Most people employ financial leverage in pursuit of positive cash flow, using financing to buy properties, businesses, or other assets that provide ongoing returns. Some assets have stronger, more reliable returns than others. If you’re in a disproportionately unreliable cash flow situation, you’ll be at higher risk for being overleveraged.
• Market volatility: Risk associated with leverage is often tied to the volatility of the asset in question. Stabler, more foundational assets tend to carry lower overleverage risks. If you suspect increasing market volatility in the future, or if you’re in an especially volatile market, you need to be more careful with the leverage you take on.
• Individual risk tolerance: Of course, you also need to think about your risk tolerance as an individual. Some people are naturally more conservative investors, while others are more risk-tolerant. In general, the older you get, the less risk tolerance you have. But this is a variable you can decide for yourself. How much are you really willing to lose?
The question of leverage and overleveraging isn’t a straightforward one to answer, since there are so many variables at play. However, with a true assessment and careful consideration, you should be able to quickly figure out whether you’re in the ballpark of overleveraging yourself (or your business).
Ty Foster is a Managing Director at Invest.net. An experienced investment professional, Ty resides in Salt Lake City, UT.