Debt and Leverage

Debt is a liability on your balance sheet. The most common form of debt is a loan, where a bank is lending you money and expects you to pay the money and interest back after a certain amount of time.

The result of too much debt can be bad for your financial situation, because liabilities are decreasing your net worth. It can go so far that your assets are worth less than your liabilities and you have a negative net worth.

Having a negative net worth is especially problematic if you are paying high interest rates. Paying high interest rates while already having a negative net worth can lead to an unstoppable downward spiral. To stop this downward spiral you need to work on increasing your income and decreasing your expenses. If you think it is impossible to stop this downward spiral, consider filing for bankruptcy.

With a more stable financial situation and a positive net worth, you can consider taking on debt as a tool. You can use it to purchase assets that you could otherwise not afford to buy. Taking on debt to buy assets, has the result, that your assets are leveraged. How much leverage you are using can be calculated with the Equity Multiplier:

Equity multiplier = Value of your Assets / Net Worth

If your Equity mutiplier is >1, you are using debt to finance some of your assets. Taking on debt to buy assets does not affect your net worth in the moment you do it. The result of using leverage is, that future gains and losses of your assets are amplified. By doing this you increase the future upward and downward potential of your net worth.

Here is some examples of how someone can consider to use debt:

Get a mortgage for buying a house:
If you use a mortgage to buy a house you have a liability to the lender and the house is an asset on your balance sheet. Usually the lender can use your house as collateral in case you are not able to pay down your liability. Another risk that you are carrying is the house losing value but therefore you are also profiting from gains in value or rent payments to you.

Studying and taking a student loan:
Taking a student loan to study means, that you take out a loan to invest in your future self. Your knowledge and education is the asset that you leverage. This case is financially beneficial if you have a lot of working years ahead of you. The result of a good education is, that you can earn a higher salary or build a better business. The financial risk you are carrying here is, that you will not be able to monetize on your education.

Take a loan to buy stocks:
This is very risky as stocks have a high volatility. If the investment goes well you will benefit a lot from using the debt to leverage your stock portfolio. On the downside you can end up with a worthless stock and a lot of debt that you have to pay off.

Finance a car:
By financing a car you are adding a car to your assets while adding a loan on the car to your liabilities. Compared to other assets be aware that cars depreciate quite fast in value. Therefore it comes with the incredible advantage of moving around a lot faster than a horse carriage.

When considering to use debt as a tool for leveraging your assets, run through the worst case scenario and ask yourself if you can handle it. If you can, compare the downside to the upside and analyze the costs (e.g. interest rates) that you are paying for the leverage.

In many cases the costs and additional risks of leverage outweigh the potential benefit.

If you feel comfortable with taking additional risks, leverage can be a powerful tool in your personal finance toolbox. If you prefer a safe and risk free management of your personal finances, stay away from leverage!