Financially secure future is something which we all dream for. To achieve this we work hard for the entire life. Setting financial goals, budgeting, learning money management skills are some steps which lead us to reach this goal.
In this path, loans act like demons and hurdles which reduces our speed and further delays our goal accomplishments. Loans are basically borrowed money which needs to be repaid along with the interest. These are also considered as debts. Well, this is the persisting theory about loans and debts.
Leverage can help you save time and money, gain expertise and more. But how does leverage work, and how can you make it work for you? From using financial leverage to make more money to transforming your relationships, understanding the power of leverage is the first step in expanding your opportunities and overall fulfillment.
Difference between Debt and Leverage
Debts are basically money borrowed by someone which is either from a bank, a private money lender or from friends and family. A debt generally comes with an arrangement that gives the borrowing party permission to borrow money under the condition. These conditions include the time period in which it needs to be paid back, the interest rate charged and several other terms.
Whereas Leverage is using borrowed money as a funding source to make more money. This is generally achieved when borrowed money is invested as capital in any business or money-making profile which has the potential to generate returns.
Benefits of leverage
- Accelerate your financial growth
- Multiply your wealth
- Can improve one’s financial well being
- Improves your risk-taking abilities
- Improve your quality of life
- Allow you to focus on other aspects of life as you become financially secure.
Steps which need to be taken
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
- Also take into account, the possibility of interest rates going up and future appreciation keeping up.
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.
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.
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.
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.
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.