Last month’s article, I shifted the focus towards investments that have always worked. But when we talk about investments, we should also talk about leverage. Now leverage or debt can be both good and bad. It can create order or chaos. I believe debt gets a bad name, but I want to go beyond our common, practical sense of leverage. To expand on what leverage actually means.
The definition of leverage, in a financial context, is to borrow money, hoping that the profits made will be greater than the interest owed (Investopedia 2019). But what about leverage in a real-world sense? Leverage, as defined by the Cambridge Dictionary (2019), is the power to influence people and get the results you want. Now that we have the definitions down pat, let’s discuss both the good and the bad of financial and real-world leverage.
The good of financial leverage is you can borrow money that you don’t have, to purchase an asset. Now, the typical example of this is buying your family home. Let’s say the home is worth $500,000. You should be paying a 20% deposit to avoid paying lenders mortgage insurance, but that’s another article. So, you have $100,000 deposit and you borrow the remaining $400,000 to technically own the home. But really the bank owns the home and you are paying them back via a home loan. If you weren’t allowed to borrow money, many people would not be living in what they believe to be their own home and a lot more families would be renting. But a good way to look at buying your family home, is that it is a forced savings plan. You are required to pay the bank back every month an interest amount on the home loan and then reduce the borrowed amount through principal repayments or they will take the home away from you. So, you are forced to earn money through trading your time (working) to be able to have enough in your bank account to pay down and hopefully off, your home loan.
Now the bad of the financial leverage is borrowing more than you can afford. To put some context into the situation with some numbers, let’s say you have the above loan of $400,000 with an interest rate of 5%. This is a hypothetical as I know interest rates are lower than this at the minute but stay with me. So, the interest amount is $20,000 and you would like to reduce the loan amount (principal) by $10,000 each year. So, $30,000 are your total mortgage repayments over the year or $2,500 per month. Now if you were earning $50,000, you would be in financial stress. Financial stress is defined as “a condition that is the result of financial events that create anxiety, worry, or a sense of scarcity, and is accompanied by a physiological stress response” (Financial Health Institute 2019). In this example, you are paying 60% of your income towards your home loan. That’s stressful and living beyond your means.
The good of real-world leverage is utilising human capital and technology to increase your productivity more than what you could simply working by yourself. As they say, many hands make light work. The more brain and computing power that can be combined, the better. A classic example of this is a group university assignment for me. If I had to do a 4,000-word assignment by myself, it would take me weeks. But dividing that work up between 4 people and only needing to do 1,000 words each can be completed in days. Combine that with the internet and you have yourself a winning match and a good pass mark.
The bad of real-world leverage, however, is relying too much on other people and technology. Continuing with the above example, group assignments could be painful if some of the individuals didn’t pull their weight. It would double the work of someone else, causing additional stress and potential conflict. In regards to technology, we now have a computer in our pocket. We can surf the web anywhere we want to. If we don’t know something, Google certainly does. I’m sure we have all relied on a GPS app like Google maps to get us to a destination, only to find it has taken us the wrong way or a longer way.
In summary, borrow less than you can afford and spend less than you earn (Thornhill 2015, p. 9), and you will be financially wealthy. Live below your means. The less you can live on, the closer you are to making work a choice and having financial independence. If you receive a pay increase, instead of going shopping and buying a new watch or the latest iPhone, save it and invest. Delay your gratification as long as you can. The longer the better, but it takes discipline and a reason why you are saving and investing. Saving for a rainy day is not a good enough purpose to go without and sacrifice now, for enjoyment tomorrow.
Cambridge University Press (2019). Leverage. Cambridge Dictionary. Retrieved from <https://dictionary.cambridge.org/dictionary/english/leverage>, accessed 17 October, 2019.
Dotdash (2019). Leverage. Investopedia. Retrieved from <https://www.investopedia.com/terms/l/leverage.asp>, accessed 17 October 2019.
Financial Health Institute (2019). Financial Health & Stress. Retrieved from <http://www.financialhealthinstitute.com/financial-health-financial-stress-in-human-services/>, accessed 21 October 2019.
Thornhill, P 2015. Motivated Money. 4th edition, Sydney, Australia.