Should You Ever Leverage Yourself?

Photo by: fairlightworks

The typical American is leveraged.  They have borrowed money to buy things.  This is not necessarily bad in and of itself, but if you start to think of your household as a business, you may stop and question whether the leverage you’ve taken on makes sense.

What is Leverage?

Leverage is the use of debt to magnify the outcome of an investment.  Say, for example, you are a company, and you trade widgets.  On each shipment you can buy widgets in one location for $10 and sell them in another for $12.  If you only had $100, you could only do this in shipments of 10 widgets and make $20 per shipment.  However if you could go and borrow $10,000, you could buy shipments of 1000 widgets and make $2000 per shipment.  Even after you paid back the party that loaned you the money, along with any interest, you would have made considerably more money per shipment.

Appreciating Assets

One of the most compelling reasons for an individual to leverage themselves is to buy an appreciating asset.  An appreciating asset is one that gains value over time.  The most common form of this in recent history has been real estate.  Leverage, in the form of a mortgage, is very common for an individual buying a house.

Even though the individual is paying interest on the money he’s borrowing, the house will (hopefully) appreciate in value at a rate exceeding the interest paid.  Thus, you might buy a $100,000 home with $10,000 down and a $90,000 mortgage at 7 percent interest. If you only paid the interest every year, you’d pay $6,300 in interest; but if the house is appreciating at 8 percent per year, you’d be making $8,000 – $6,300 = $1,700 per year after the financing fee.  In this case you’ve levered your $10,000 up to make a tidy profit.

Depreciating Assets

While we can never know for sure if an asset will appreciate, housing can be a fairly safe bet since it also provides a basic need.  Even if your house does not appreciate enough to offset your interest, you are also getting a place to live in the deal.

Unfortunately we also typically leverage ourselves to buy depreciating assets, or assets that lose value.  Most of us buy a car with a car loan.  As soon as we drive the car off the lot it begins losing value.  Meanwhile we’re also paying interest on the money we borrowed to buy the car, so we’re losing money in two ways.  While we can’t guarantee our house will gain value, we can nearly guarantee our car will lose value.

Shaping Your Thinking

You should start thinking of your life like a business when it comes to leverage.  While it might make sense to borrow money to buy a house, does it make sense to borrow money to buy a car?  Even worse, does it make sense to use a credit card to buy a flat screen television?  At least the car provides a necessary function.  You should assess what kind of assets you’re buying when you’re spending your money.  Things like education may be worth putting yourself in debt since they have the capacity to increase your earnings.

Ultimately the wisdom of a leveraged purchase should be viewed in light of two things:  The likelihood of it appreciating and the utility of the purchase.  The less likely an asset is to appreciate in value, the less likely you should be to incur debt to finance it.  It makes you wonder why so many of us incur debt to purchase something that can’t possibly appreciate and serves no important purpose.

One Response to “Should You Ever Leverage Yourself?”

1. Ashley says:

   August 26, 2009 at 5:15 pm

   You make good points and put it in a way that makes it easier to rationalize. I don’t buy new cars for this reason and recently made a decision to pay cash for my one. You’ve got to find a way to come out ahead!