“If there’s not enough money in the bank account, you don’t spend it.” - Charles Schwab, Charles Schwab Interveiw: What I’ve Learned, Esquire, February 2010
Over the past couple of weeks, I’ve talked at length about debt. However, sometimes I mentioned it under a different name: leverage.
People with a business or finance background will recognize that word, but I realized that not everyone will understand that term, since it’s not talked about outside of investing and financial news. This is concerning to me, especailly since there is $0.84 of debt for every $1 in the US. So, to help close that gap, I am going to try and simply explain the concept of leverage in finance, and what it means for the everyday consumer and investor.
What Is Leverage?
In short, leverage is debt. Speciffically, leverage in finance is the process of borrowing money, to invest in projects and assets that will grow in value more than the interest rate you have to pay on the debt.
Think about it this way, when you want to lift something that is heavier than you can lift on your own, you use a lever to lift it from father away. The power you gain from that lever is called leverage. Financial leverage is not different, except now the lever is borrowed money.
Sounds simple enough right? Well the concept itself is simple, there are a few important insights we need to bring up, starting with th most important one: leverage requires you to chase higher returns, raising your risk.
High Risk, High Return
As a general rule, if you are going to borrow money from someone, you are going to compensate them for that ability to buy to things (purchasing power). The interest rate you pay on borrowed funds is that compensation. That interest rate is calculated based on a variety of factors, such your risk level, inflation, and others. One consideration is the rate on US debt (bonds and T-bills). Considering the fact that the US government has always paid back bond holders, and is one of the easiest assets to sell, many lenders and investors use treasury rates as a test for whether they should invest or lend their money to someone.
Currently, the US 1 Year treasury currently pays 4% to those who want to lend their money to the US government for a year, the US 10 year pays around 4.4%. In the case of leverage in finance and investing, this means that a project must return at least 4.5% (bare minimum) in order for lenders and investors to consider parting with their hard earned money. Higher returns imply higher risk, so if someone borrows money to buy assets, they need to take on more risk to pay back their loan and make a profit themselves.
Sometimes this risk is insanely high. Short selling, or borrowing a stock from someone else and selling it with the hopes that you can buy it back for cheaper in the future (pocketing the difference), techinally has infinite potential risk since a stock price could rise in price infinitely. Margin trading, or borrowing funds to trade more stocks than you have, raises risk since trader are required to mantain a certain balance in their accounts at all times (called margin). If an investor (or group of investors) take out debt to buy a company, called a leveraged buyout, that doesn’t make enough money to make the loan payments, it could lead to bankruptcy, legal action, or both.
You get the idea, when you take out debt to buy assets, your risk goes up since you have to chase higher returns. However, that’s not the only risk leverage has. Using leverage also requires you to be more disciplined than you otherwise would be.
More Leverage = More Discipline
In the 1920s, stocks were the new “big thing” and consumers wanted to buy more stock by any means. Average people bought stocks with their savings, they pooled their money to buy them, and even took out loans to buy them. The banks were far too eager to lend the money, leading to a massive stock bubble.
When the US Stock Market crashed in 1929, all that money vanished. The stock market plummeted, banks failed, and investors lost everything. The hype of the 20s made people forget financial discipline and cost them dearly. When you borrow funds to buy assets, the person you borrowed from has a right to that asset if you don’t pay them back. Because of that, your actions now effect multiple peopl. The effect of your choices, good or bad are magnified. That’s one basic reason why leverage finance also has stricter legal requirements. If you are a “buy and wait” kind of investor, using leverage may be too big of a risk.
Should I Use Levarage?
Now that we’ve explained it the question is, should you use leverage in your investing journey? In my opinion, the answer to that depends on three questions:
What’s my risk tolerance? If a lot of risk makes you nervous, levearge might not be for you.
What return do I need to get? Remember, debt requires compensation, if you don’t need a high rate of return, leverage may be uneccessary.
Finally, how big is your investment? Personally, I don’t think the average investor needs to take out debt for buyings stock. However, if you are looking to buy a company, for example, an SBA loan may be what you need. Like everthing in investing, leverage is a tool, which you need to learn about before using.
Hopefully this article helped you understand investing a little better. If it did, tell me in the comments what caught your attention the most!
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Tyler Kreiling, WealthNWisdom, Founder and Head Editor
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