By Dr. Daniel Smith, WCI Columnist
“Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.” — Archimedes
Leverage has practically become common investing parlance today. You’ve got debt detractors like Dave Ramsey who believe leverage is investing apostasy, the fast track to the poor house. On the other side of the conversation, you’ve got Thomas Anderson who literally wrote the book The Value of Debt (i.e., leverage) and who advocates up to 30% of your net worth leveraged with your “human capital” as functional collateral. Further stoking the conversation about leverage is the historic amount of capital being pumped into our nation’s economy by politicians. With bond yields low, cash generating a negative real return, and stock prices at 20-year-high P/Es, the question of how to safely boost returns deserves a thoughtful exposition on the use of leverage.
What Is Leverage?
Returning to your physics 101 class, leverage is the use of a tool to functionally increase force by increasing the lever arm through which force travels. In finance, leverage is the use of borrowed money or securities to finance a transaction in the hopes of producing a higher return. Examples in our sphere include borrowing for medical, dental, or law school or taking out a loan to purchase or start a practice. The downside is that borrowed money must be repaid and with a reasonable rate of interest to whoever lent you the money. If your financial plans are poorly made, then you’re stuck with the debt but without the return ostensibly meant to repay it like this poor fellow.
Though some will pedantically say that no leverage is good leverage, I would argue that leverage is just a tool. When used properly, tools serve a good purpose and make us more efficient; picture trying to dig a hole without a shovel. When used improperly, tools are not useful and can cause harm; now picture using a sledgehammer to drive finishing nails into your drywall.
What Does ‘Good' Leverage Look Like?
Good leverage generally has three qualities: the borrowed amount befits the need, the borrowed amount is non-callable, and the borrowed amount’s interest is reasonable. A good example of leverage embodying these qualities would be a mortgage for your home. The amount of the loan is usually a sizable fraction of your home’s value but not more. It’s non-callable in that no matter how badly the bank or Fannie Mae needs your monthly mortgage payment, they can’t call you and ask for the balance of the loan or for payments to be made more frequently than your mortgage specifies. The rate of interest for most mortgages in this country is fixed over the term of the loan, and it can be shopped through banks, credit unions, or mortgage brokers. There’s also the bonus of deducting the interest from a mortgage on your taxes if your itemized deductions exceed the standard deduction.
Clearly, there are exceptions for mortgages. You can get a “fixer-upper” loan which covers the cost of the property and renovation costs. You can also have your mortgage accelerated (which means the full amount is immediately due) if you don’t make the payments. Last, you can choose an adjustable-rate mortgage (ARM), which can vary based on fluctuating interest rates. However, on the whole, mortgages are an example of a reasonable use of leverage.
For my own part, I recently had the opportunity to invest in a real estate deal in which the conservative estimate of cash-on-cash return was around 9% before equity pay-down. After I’d committed myself to the deal for a low five-figure amount, I soon found a significant portion of my roof had begun to leak. Not wanting to spend my emergency fund on either the deal or the roof, even though it’s arguable that the roof might have indeed constituted an “emergency,” I opted for a home equity loan. Not only is this tax-deductible as I was ostensibly using the money to pay for the roof, but it freed up cash for me to execute the real estate deal. I was, in effect, borrowing at roughly 3% (before deducting the interest on my taxes) to invest at a presumed 9% cash-on-cash return, not counting capital appreciation or equity pay-down.
What Does ‘Bad' Leverage Look Like?
Doesn’t Fit a Need
If good leverage looks like a mortgage, bad leverage looks like a credit card or margin loan on a brokerage account. Credit cards, by definition, give you access to money you wish to have access to quickly, even if you don’t have it yet. It’s a rolling line of credit at a high-interest rate. If you’re reading this blog and out of training, then a credit card is likely not a true need. Instead, it's a device of convenience. The best that can be said for a credit card is that you can earn points or cash back on purchases you would otherwise make with current cash. Instead of a credit card, you can easily use a debit card for most small- or medium-sized purchases. So, credit card debt fails the first test of “good” leverage.
Is High Interest
Credit card interest is exorbitantly high. It’s perhaps not quite as high as a payday loan or the rate your bookie charges on the local horse races, but it’s bad enough. Nobody really arbitrages credit card debt and comes out a winner, except maybe if you have an introductory grace period of several months where you can use the money elsewhere for something like filling up a retirement account. Even then, is that few thousand bucks you manage to stuff into your 401(k) as a resident really going to make a big difference over your lifetime of investing? Quick use of the future value function in Excel tells me that investing $3,000 in a retirement account which compounds at 5% real return will only net you a little less than $13,000 in 30 years. One large, unexpected expense that exceeds your emergency fund balance leaves you at the mercy of that 20+% APY interest rate on the credit card, compounded daily, until you pay it off.
Margin loans are a spectacular way to put yourself behind in investing. Not only is there an interest rate on the loan (Interactive Brokers is the lowest rate I’ve seen at 0.75% for “qualified investors”), but the loan is callable. You make a bet that stock “RISK” is going to the moon from its current $100 price and call your broker who is only too happy to loan you $10,000 to fulfill your dreams. Your broker pockets the commission and then uses your existing portfolio of $20,000 of stock “GONE” as collateral.
Then, Elon Musk tweets that he’s bought the direct and only competitor to “RISK” the next day and is pumping a half-billion dollars into the firm to make it the dominant force in the market. “RISK” plunges 40%, and your castle in the sky morphs into a mud hovel. Recall that while your debt to the broker is still $10,000, your newly-acquired portion of “RISK” is only worth $6,000. Your broker politely rings you and asks whether you’d like to cover the shortfall with cash or if you'd like to liquidate your portfolio of “GONE” instead. Salt, meet wound. Your broker doesn’t care about your belief that “RISK” should rebound just fine. They're not interested in waiting on that possibility nor are they willing to cover your loan for you. With a smile, your broker calmly submits the sell order on your portfolio of “GONE.”
Storytime again. Before I ever read The White Coat Investor, I was of the opinion that all doctors did (or should) live in opulent mansions, drive luxury cars, and dress to the nines. To that end, I decided that my first purchase out of medical school should be a BMW—a new BMW, and a lease at that. At that point, I probably should have read The Millionaire Next Door before even the White Coat Investor. It was a 128i, and I remember the black-on-black color scheme, the six-speed transmission, and the sporty look with which I charitably envisioned myself while driving it.
OK, rose-tinted glasses off now. I made lease payments on a car I didn’t own with money I hadn’t yet made, and I was about to move to a state where there’s a 6.6% ad valorem tax on the “fair market value” of my new luxury vehicle . . . *ahem Georgia.* By the way, did you know that the state determines its own fair market value? Very convenient.
Anyway, at the end of my lease term, I own absolutely 0% of the car but BMW could generously sell that same car to me and “give” me a portion of those lease payments toward the car’s sale price. In reality, they’re just discounting the price of a formerly leased car and would probably sell it at that price to any Theresa, Dianne, or Henrietta.
Because I loved that car so dearly, I decided to buy it. Fun fact: in the state of Georgia, if you register a leased car in the state, you pay the ad valorem tax. If you then purchase that same car from the company, you pay that ad valorem tax again to the Peach State for the privilege of driving the exact same car down the exact same roads.
But how exactly does this really relate to leverage? The first is that I didn’t have the money to buy the car, and so I effectively rented the right to use the car for the next three years, paying on a monthly installment fashion. I essentially borrowed money from BMW for the rights to use its car at a price the company set. Doesn’t leasing sound like a sound financial decision to you? The second is that this particular kind of debt came with hidden costs as most do, and you can tell I’m still particularly salty about having to pay that ad valorem tax twice. The third is that the monthly payments stretched my resident budget much thinner than it needed to be, which wouldn’t have been the case if I’d have either kept my current car or purchased a beater.
How You’re Using Leverage Already
Most of us already use leverage of some sort, whether out of convenience, financial torpidity, or necessity. Let’s run down a non-comprehensive list of common uses of leverage of which you may not be aware.
You own stocks, and many stocks are leveraged. Many publicly traded and private companies issue bonds, which is debt that they’ve guaranteed against future income so they can grow or maintain operations. The debt that these companies issue is bought by other entities for the purpose of securing that coupon or interest payment. Enron is a classic example of a company built on mountains of debt which it used to purchase companies, build gargantuan energy infrastructure, and pay huge bonuses to executives in anticipation of future earnings. The Smartest Guys in the Room by Bethany McLean is a fascinating look into the now eponymous tale of financial malfeasance if you’re looking for some continuing financial education until WCICON22.
You have a mortgage. While interest rates are tantalizingly low at the time of this writing, mortgage debt is still leverage. You’re using borrowed money to finance other things in your life: groceries, vacations, furniture, daycare, utilities, that new Tesla Model Plaid, etc. If you have mortgage debt, that's perfectly fine. Just know everything you buy until then is on borrowed money. As an aside, did Elon Musk have to pay royalties to “Spaceballs” for appropriating the “Plaid” moniker?
You have a home equity loan or home equity line of credit (HEL or HELOC). Similar to the mortgage, this is also borrowing against your home, ostensibly for needed repairs or renovations. Similar to mortgages, you can deduct HEL/HELOC interest on your taxes as long as you’re using it to repair or remodel your home.
You have real estate used for business. Of course, you think leverage is the main mechanism by which most individuals benefit from real estate in the first place, myself included. However, as we’ve seen with eviction moratoriums and abandoned offices during the pandemic, cash flows from real estate are not a sure thing. I’d suggest making sure you can pay the mortgage note yourself or carry large cash reserves if you’re a small-time landlord. Alternatively, look to diversify among multiple properties or occupants if you’re a landlord of more ample means.
You own leveraged ETFs. Most leveraged ETFs use derivatives to “control” more securities than the fund could buy outright. While some funds lever safer securities-like bonds in a “risk parity” style portfolio, most funds are levering equities. Those ETFs which leverage equities outright, sometimes with a generous bond allocation as ballast, simply make a bet on the long-term direction of equities and hope they can hold on for the ride. I suppose they don’t call it a bull for nothing. These, I think, are the most interesting, because the conventional wisdom is that, over a long enough time period, equities outperform bonds. However, economist Gary Shilling (or maybe it was John Maynard Keynes?) presciently noted, “The stock market can remain irrational longer than you can remain solvent . . .” One more thought on leveraged funds. The use of leverage isn’t free. Options are paid for via a premium, and that premium is paid at purchase. That, combined with “leverage decay” (the principle that high volatility diminishes returns) and the inherent tax liabilities of very active management, makes leveraged ETFs more risky than people realize, even if you’re right.
You have student loan debt. Regardless of the political winds, if you have student loans you owe that money to someone until it’s paid back or forgiven on your behalf. Some student loan forgiveness is even considered a taxable event, and it may still be a taxable event if it’s “forgiven” by the government. Imagine your $200,000 loans are forgiven, only for the IRS to attribute that amount to you as income. Happy April 15! Forgiveness or not, student loan debt is one of a few debts that can be shopped around for a lower rate of interest. If it were me, I’d take the sure thing of a lower interest rate than bet that Uncle Sam looks upon my six-figure salary with financial solicitude.
You have credit card debt, personal loans, car loans, money you owe your bookie, etc. I don’t think I need to discourse in depth about why these are 1) unnecessary for high-income professionals or 2) incredibly financially injudicious. Yeah, maybe that car note is six months interest-free, but unless you have the cash ready to hand to the dealership at the end of that six months, you’re playing a sucker’s game.
Judicious Uses of Leverage
Let’s forgo for now discussions of leveraged ETFs, options, futures, and margin trading and look at a realistic leverage scenario in which most of us will find ourselves.
You’re 40 years old and settled into a career with a spouse and two children. Your new home, cheaply procured with today’s splendid mortgage rates, is serviced by a mortgage of $400,000. You and your spouse both work and contribute the maximum elective deferral of $19,500 each for, conveniently, $39,000 per year. You already hold a three-month emergency fund (knowing that your disability insurance policy kicks in after 90 days). Your spouse, who happens to be an avid reader of investment literature, believes that long-term equity returns will be a nominal 7%, while your mortgage is at 3%. Using your handy future value calculator, you calculate that the 4% arbitrage (7% assumed return of equities minus the 3% you pay for use of the bank’s money via your mortgage) of $39,000 per year over 30 years should return around $2.2 million.
The above example is an excellent use of leverage. You assume (hope?) that the market will return more than what the costs are of borrowing that amount. Odds are that you will be right. There are a few caveats, however. One admittedly small source of friction is that you’re now required to increase the amount of your emergency fund and sustain the drag on the cash that you must keep. The extra amount totals to be $4,975 (mortgage payment of $20,407.70 per year divided by 12 months multiplied by 3 months) held in cash for the next 30 years. This would only amount to ~$40,000 if invested at 7% over 30 years, but it’s worth mentioning.
The bigger worry is that the market may not return what you thought it would. We’ve been the recipients of a rather superlative bull market over the last decade, and market cycles are still a real and present risk. You may be mentally kicking yourself if the next several years’ returns look meager. Worse still may be a scenario in which you have unexpected expenses above that which can be covered by your emergency fund. Sure, you can always get a 401(k) loan, a HELOC, or a hard-money loan; however, nothing to which you can get access will be without cost.
The last item to consider in this scenario is that you’re not going to immediately receive the difference between your investment and your loan. If you’re investing at 7% in a retirement account and being charged 3% interest, you’re probably not accessing those 7% returns to cover the 3%. That means you’re cash flowing the entirety of the mortgage payment while sending the retirement account contributions to whatever custodial institution is keeping them.
Let’s throw in one more wrinkle to this leverage example and say you’re financing the same home for the same amount. However, now you’re investing the $39,000 per year in a taxable brokerage. Assuming the same 7% equity returns, you’re faced with a new set of questions. Do you cash flow the mortgage while not touching the money in the brokerage account? If so, you’re still having to trim your monthly cash flow by the mortgage amount as well as pay taxes on dividends and capital gains from your investment (this is about a half-percent per year for something like VTSAX at the top marginal tax bracket). If you were to take those returns out every year to pay the mortgage, then you’d pay taxes on (most of) the returns at your marginal tax rate because non-qualified dividends and short-term capital gains are taxed as ordinary income.
I’m going to assume that most readers of this site pay 24%-37% at their marginal federal tax bracket. Let’s say that you pay at the 32% federal level; this lowers a 7% return to an after-tax return of 4.76%. (although could be a little better if the return is solely qualified dividends and LTCGs). After your mortgage payment of 3%, you’re only netting 1.76%. Over 30 years, you’re still ahead $1.5 million, which is far from chump change, but it does require you to actually *invest* the money instead of spending it.
This post is getting a bit long in the tooth, so let’s wrap up with a few parting thoughts:
- Good leverage is non-callable, with a reasonable interest rate, and not more than is needed
- Most readers of this blog don’t need to use leverage
- Leverage sometimes produces greater returns but always incurs a demand upon your finances
- Judicious use of leverage can drastically increase your returns
- Most leverage use isn’t judicious
Do you use leverage in your investing life? Do you think it's a good tool, or do you just try to avoid it because you're worried about being sledge-hammered? Comment below!