It’s hard to avoid the buzzword of “leverage” in personal finance and investing, but not all leverage is created equal. We often hear people recommend leveraging debt and using OPM (other people’s money) as the way to get ahead and be successful. And while debt can be a useful tool when handled properly and carefully, I’d argue this leverage isn’t as powerful as its alternative. Below, we cover the power of leverage and the problem with financial leverage when it comes to debt.
- Financial leverage costs money through fees and interest, which can significantly cut into the monetary benefit
- Assessing just the purchasing power of financial leverage leaves an important part of the equation out: risk
- When you aren’t financially leveraged, you actually have more leverage to live the life you want, versus the one you have to have to afford your lifestyle
- Being about to walk away is one of the most powerful negotiating tactics (and thus leverage) you can have
What is leverage?
In business terms, leverage is typically defined as using borrowed money (AKA other people’s money) in order to invest.
For a small business, this could mean securing a SBA loan for startup capital or buy equipment on payment that are necessary for an expansion.
In personal finance, financial leverage could be a mortgage to purchase a home in order. You might even secure this mortgage to invest in the stock market with the capital you would otherwise need for the purchase. It’s also a common term in real estate investing. By buying multiple rental properties that are mortgaged, you can leverage the properties to build a real estate empire that continues to grow and grow.
How financial leverage works
By borrowing leverage in the form of debt, you gain purchasing potential with the money you have. This extra purchasing power can buy additional assets, whether they are houses or investments like stocks.
Financial leverage is popular because this can increase your earnings potential.
Let’s look at a quick example to see how this plays out.
Say you have $250,000 saved in a taxable brokerage account above and beyond your retirement accounts. First of all, go you! You’re killing it.
With this nest egg, you’re interested in purchasing your first rental property. You have your eye on a duplex that you could live in half of and rent out the other half for income.
The duplex in mind just happens to cost $250,000. How convenient! As you consider how you want to purchase the property, you have a few options. You can:
- Buy the property outright (assuming you won’t have a huge capital gains tax bill)
- You can put a hefty down payment down and save some of the cash in reserves for things such as repairs, vacancies, upgrades, etc.
- You can get the largest mortgage possible on the property and leave your $250,000 invested in the stock market so it continues to grow while your rental income “pays your mortgage” on the duplex
Under the power of financial leverage principle, you would choose what’s behind door number three. The debt of the mortgage would give you the greatest leverage to continue to invest and grow your wealth.
I recently discovered a term called BRRRR, which is popular jargon in real estate investing. It stands for:
- Buy
- Rehab
- Rent
- Refinance
- Repeat
This takes the concept of financial leverage and turns it up to 11. By using some of the investments you saved for upgrades, you increase the market value of the property, which can also get you a higher monthly rent. With the higher market value, your equity grows, and thus your financial leverage potential also grows. With the BRRRR method, you milk that property for all the leverage you can get so that you can do the same with another leveraged property.
It’s like free money, right? Why doesn’t everyone do this?!?!
There are a few reasons, which we’ll cover next.
The cost of financial leverage
The first point to make when considering financial leverage is the financial cost of obtaining said leverage. There are few banks or other lending agents out in the world that are going to offer you a 0% loan, so it costs you money to obtain that leverage, which can significantly eat into the benefit of getting that leverage.
Let’s look at two examples to show the cost of financial leverage.
The cost of financial leverage using a mortgage
Let’s go back to our duplex example above. You aren’t sure whether you want to take advantage of financial leverage a la a mortgage on your dream duplex or not, so you’re weighing your options.
The average stock market return over the last 30 years is about 10%. You might look at that and say it’s a no brainer, of course you’ll borrow money from the bank instead of selling off the funds you have in your taxable brokerage account. That’s 10% more, which can go a long way over 30 years.
But don’t forget that while you’re earning an average 10% in the stock market, you’re also paying interest to your mortgage lender. At the time of this writing, the average interest rate on a 30-year fixed mortgage is around 7.5%. That’s going to take a huge chunk out of your leverage.
It’s important to note the difference in terms here too: stock markets grow on average while a fixed mortgage rate is, well, fixed. If the stock market is down 15%, you still have to pay your lender the 7.5% on your balance.
We did a deep analysis into the topic of financial leverage and mortgages with our article on whether you should pay off your mortgage early or invest instead and looked at three different interest rates: 2.25%, 4.0%, and 7.25% using three real-world examples we collected from our brigadiers. Not only did financial leverage work out in the opposite direction that what pop culture tells you in favor of paying off the mortgage at 7.25%, but the same was true even at 4%!
Now at 2.25%, the math actually worked out in favor of the popular opinion to leverage OPM and keep that mortgage, but only if you invested instead. If you spend that money on vacations or eating out or extracurricular activities for the kids, then you’re actually worse off, the same as everyone else.
The cost of financial leverage using a 0% interest car loan
So above, we say that a 2.25% interest rate makes sense mathematically to employ financial leverage. That means 0% is a no brainer, right?
As is the case with almost everything we cover, the answer is that (say it with me now) “IT DEPENDS!”
What we didn’t factor into the example above was the additional closing costs for a mortgage, which also eats away at the power of financial leverage. There are also fees you’ll pay for arranging a car loan, though they usually aren’t as steep as mortgage closing costs.
On top of loan fees, consider the purchase price as well. I don’t know of any used car dealerships that offer 0% financing. 0% financing is a gimmick to get buyers in the door and in the seat of the latest and greatest models on the lot. This means you’re going to be eating all the depreciation that happens for that vehicle in the first few years of its life. You’ll also likely have less negotiating power on the purchase price, and may even pay a higher sticker price so they can bake in the lost interest into the purchase cost.
This math is a lot harder to see, but is as equally important. If you want to see how the power of leverage can work in your favor if you avoid a car loan, explore our article on the true cost of owning a vehicle.
Risks associated with financial leverage
The biggest piece of the equation left out in the example above is the risk factors associated with financial leverage. Along with the financial cost of leverage, you should also consider the risk of being leveraged. In our humble opinions, this is the biggest disadvantage to financial leverage and why we in general don’t mess around with debt. Debt isn’t some cute little Pygmy Puff. It’s the Monster Book of Monsters. If you aren’t careful, debt will bite your fingers off.
Financial educator Dave Ramsey talks about this a lot when he explains why he only pays cash for real estate investments (no, that’s not a typo, it’s his shtick). He had banks call all his mortgages at once, and he didn’t have a million plus in cold hard cash sitting around to cover the calls. He ended up having to file bankruptcy and lost everything.
While this is an extreme example, it is a cautionary tale against the BRRRR method of real estate investing for sure. And it’s a general life principle we like to live by.
We sleep better knowing our car can’t get repossessed in the middle of the night because we had to choose paying my medical bills over a 0% interest car loan. And we sleep really well knowing a bank can’t come take our house away and leave us on the street with unruly neighbors.
This doesn’t mean we’ve never had a mortgage. Buying a house in cash in our mid-twenties would have left us in a hellhole in murder stab central. Instead, we intentionally set a ceiling on the purchase price we would offer that kept our mortgage low and manageable, and then we paid the mortgage off in about 7 years instead of 30.
This also doesn’t mean we’ve never had a car loan. We both financed cars in college, because we needed wheels to get to work to pay for school, and needed to get to campus to graduate with our degree so we could make money.
(This one is an inside joke for my husband <3)
We both got used cars, though, and made a point of paying them off as soon as we got stabilized in our careers and had said money. Ditto on our student loans.
When you treat debt like the danger it is, OPM and financial leverage become a much more balanced conversation.
The leverage of power when you aren’t financially leveraged
Here’s the craziest thing we’ve learned from becoming debt free: when you aren’t financially leveraged, you actually have more leverage in your life.
What’s going on? What’s happening? What are you telling me?
I know it’s counterintuitive, but hear me out.
When you don’t owe anyone anything, you get to make decisions for yourself. You don’t have to stay in a shitty, toxic work environment because you can’t afford to miss a paycheck. You don’t have to debate if you can really afford a cancer treatment that could save your life. And when someone tries to overcharge you for something, like a car on a 0% interest loan, you have the power to walk away and wait for a better offer.
And boy howdy, being about to walk away is one of the most powerful negotiating tactics (and thus leverage) you can have.
When I decided I wanted to leave my last job, I interviewed at several places. They wanted me more than I wanted them because I didn’t need their paycheck to pay back OPM. So guess who got their offered salary increased at every job she interviewed for? And when a company tried to say I would have to be on an on-call rotation for weekend work and I said that was a deal breaker for me (because I had to leverage to be able to walk away), all of the sudden, I was exempt from weekend call if I would just please consider taking the job after all.
Power, my friends. POWER!!!
The irony is that I ended up not accepting any of those jobs. I ended up taking a pay cut to strike out in an entirely new career path to pursue my passion of education and to get paid in part to write (hello, childhood dream) because I finally had the financial freedom and thus leverage to do so. This has been so rewarding and I truly love my job, as well as what I now have time to do here at The Budget Brigade. That wouldn’t have been possible under the stressful schedule of my former job or any of the other jobs I worked for that offered higher salaries for higher commitments of my time. If we’d still had student loans and car loans and a mortgage, I wouldn’t have made the same decision. But since we don’t owe anybody anything, I could leverage that power to create a life I actually want to live, versus one I had to live to be able to afford my lifestyle.
The same can be said about leverage on the other side in real estate. If you have the power to walk away from a purchase, you can leverage that for a better deal with a lower purchase price. We’re going through this process right now. Listing agent wants us to sign a contract that transfers all the risk of purchase and at closing to us? No thanks, I can wait. Seller wants to play hardball and try to negotiate higher than the property’s worth? Hard pass, good luck with some other sucker looking for leverage.
The final word
There are some situations where mathematically, financial leverage works in your favor and allows you to accelerate your journey to financial independence. In general, however, there’s usually more leverage in not being financially leveraged through debt.
If you’re interested in getting out of debt but don’t know where to start, check out all our free resources to help you become debt free. If you need more guided, personal advice, drop a line to the hive mind in our budgeting and personal finance Facebook group, or explore our personal finance coaching.