Famed investor and billionaire Warren Buffet once said, “My partner used to say there are only three ways that a smart man (or woman) can go broke: liquor, ladies and leverage. The truth is – he only added the first two because they started with L – its leverage.” Keep that in mind as we learn a little bit about leverage.
What is Leverage?
Leverage is another word for debt in the finance industry, and almost all corporations capitalize on leverage to some degree. Here’s why: Leverage AMPLIFIES returns. To be very clear, leverage does not increase returns, it amplifies them.
Amplifying Returns
I like to think of leverage like alcohol for three distinct similarities.
1. A Little Bit Can Be Helpful and Productive
Debt allows you to purchase things you could not purchase without it. Homes are a great example of how Americans benefit from debt. Additionally, debt can free up your capital to invest in other ventures.
For example, say you have two investments that both cost $10,000, but you only have $10,000. You are confident that both will yield a 10% return over the next 5 years. If you have the credit capabilities, you could go borrow $10,000 and fund half of each of the investments with debt! If your rate of return is higher than the interest you pay, you’ll make more money!
2. Too Much Can Absolutely Ruin You
In addition to amplifying your bad returns, you also must pay the person who is providing you the leverage! If you can’t afford to make the interest payments on the debt, you go into default. Additionally, the more debt you take on, the riskier you become as a borrower. This causes the interest rates you pay to rise. Check out this article on a fascinating phenomenon of negative interest rates!
For example, if you fail to make your interest payments in our housing example, the lender would have the right to claim your house (in a secured debt situation). There is also unsecured debt, or debt not tied to a specific asset. This debt charges higher interest rates due to being more risky, and this affects the cost of equity.
3. Neither Makes A Great Experience
Let’s look at an example of how debt can both increase returns and losses!
Let’s say you buy a house for $100,000. You take out a loan for $30,000 and put $70,000 in equity into the home. Over the next 5 years, the housing market does well, and your home appreciates to be worth $200,000! Your Internal Rate of Return (IRR) would be 19.4%. Talk about a great investment!
Now, let’s look at a different perspective. You buy the same $100,000 house, but instead you take out a loan for $70,000 and put $30,000 in as equity. The market has the same explosive growth over 5 years and the home appreciates to be worth $200,000. After paying off your debt, your IRR would be an astonishing 34%, which is a ludicrous return.
Lets take a quick look at a bear housing market instead of the house going to $200,000, it drops from being worth $100,000 to $50,000
Scenario 1 (high equity) – You would still have $20,000 in equity in your home. (IRR of negative 22.16%)
Scenario 2 (high leverage) – You would have to pay an additional $20,000 just to get back to $0 equity! (IRR of negative 192.21%)
This doesn’t even consider the interest you have to pay on this debt!
Key Takeaway
Private Equity firms, and other sophisticated investors have made a lot of money capitalizing on the benefits of debt. However, it is important to remember that debt is a double-edged sword. Although you can greatly increase your returns, you can also dramatically increase your losses too! When in doubt, take the word of wisdom from the Oracle of Omaha and only take on debt that you can make payments on!
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