A few months back, I met a friend of mine who came from the US on a holiday. He has done quite well for himself over the last 20 years in the US, and has built a fairly large investment portfolio. He has also successfully built a healthy real estate portfolio over the years in the US. Discussions veered towards that, and he said something that made me sit up.
His words were “I love Leverage.”
When he said this, my immediate reaction was to disagree. Loans are bad, and one should be debt-free in one’s pursuit of financial well-being. That said, I have since realized that debt is not as one-dimensional as one thinks it is. We have also faced this situation when we make financial plans – when people have debt on their personal balance sheet, and some cash comes in, what should one do? The use of the word “leverage” instead of “debt” somehow made all the difference for me to look at it in new light.
Leverage is not exactly the same meaning as debt. So, debt, in itself, has the meaning “borrowing that needs to be repaid;” it has somewhat negative connotations, not only financial but also cultural. On the other hand, leverage has relatively positive connotations, meaning “to use something to advantage” or in a financial sense, “to borrow since one can earn better on it.”
Coming back to the original question, we can now see that we can look at debt differently and build some simple rules around it, which can be generally followed, towards one’s financial well-being.
Rule 1: Take a loan only when appreciation opportunity is real
-Taking a loan for buying an appreciating asset such as an apartment makes sense, as long as you have evaluated the opportunity well and are confident about the long-term appreciation potential of the house. An easy way to understand this is:
Yield (capital appreciation + rental) >= rate of interest
-For e.g., in case you buy an apartment as an investment and leverage it through a loan at 8 per cent, assuming even a 2 per cent long-term post-tax rental yield, your house should appreciate at a rate of at least 6 per cent (8-2=6), preferably a bit more.
-Also take into account, the possibility of interest rates going up and future appreciation keeping up.
Rule 2: Don’t use leverage when downside risk is high
-Leverage opportunities exist only when prospects seem uncertain (there is risk involved). When there is uncertainty, there is volatility, and hence the prospect of negative returns and loss of capital also exist.
-This is exacerbated in opportunities that are highly liquid. In leveraged situations, such cases of negative returns can wipe out capital and lead to a huge liability on your head. E.g., borrowing to invest in the stock market is highly risky and should never be attempted.
-A corollary to this rule is also that any short-term leverage opportunity that promises significant gains is also risky and downside risks in such cases should be carefully evaluated.
Rule 3: Leverage should be a choice, not a compulsion
-Taking a loan is nothing but borrowing from your future earnings to fund your present. So, unless the asset you are borrowing for is earning more than the cost of borrowing, you are leaving your future under-funded.
-Hence, living within your means is important before you try using leverage. The ability to make a choice between liquidating existing assets versus using leverage to raise capital should always exist, and allows for rational assessment of investment opportunities.
-E.g., taking a zero-interest EMI option for buying white goods for your house is a good idea, provided you have clear visibility of income flows over the next 12-18 months tenure of the loan, so that repayment is a certainty, and you are living within your means.
-Similarly, using a credit card for purchases is fine, as long as you use it as a charge card, and pay it off fully on the due date. Revolving debt on a credit card because you cannot afford to pay it off is as good as a criminal offense that you are committing against your financial well-being.
Rule 4: Always have a plan (and a backup) for your loan
-In case the leverage decision passes the tests of Rules 1, 2 and 3, then this rule becomes important. Always be clear about the tenure of the appreciation opportunity, as well as your ability to repay your loan over this tenure, through clear visibility and assurance of future earnings.
-Second, it could so happen that during this tenure, either drying up of cash flows to repay the loan or the depreciation of the underlying asset might mean an earlier-than-planned repayment of the loan. In such cases, your ability to repay the loan through other existing assets is an important aspect to help you decide whether you should use leverage.
-E.g., a vehicle loan you are unable to repay due to insufficient cashflows. In such cases, liquidating the underlying asset (car) may not be possible, and hence having other financial assets that you can liquidate is essential.
Rule 5: Evaluate every loan as an option that fits in your overall plan
-Last but not the least, every such leverage option that you evaluate should be subservient to your overall financial plan, and the priority of your financial goals within that plan. Taking leverage decisions without considering what it is doing to your overall financial situation, will harm your long-term financial well-being.
-E.g. Using leverage to fund lower priority goals such as vacations through personal loans, when higher priority goals such as retirement or buying a house or children’s education remain under-funded, is poor use of your money and a clear case of “over-leveraging.”
It is important to evaluate every leverage opportunity using the above rules, before you take a decision to take a loan. Remember, in your long-term wealth building journey, leverage, if used wisely, can be an accelerator, and if used unwisely, can put the brakes. Simply put, debt is bad, but leverage is better.
(The writer is a financial planner and NISM-certified investment advisor, and co-founder of Finwise Personal Finance Solutions)