Whether it be buying a house, financing a car, or constructing your ideal portfolio, debt levels are always a key consideration. But how much debt is too much? There are countless stories of individuals and businesses over-leveraging themselves and getting crushed under the weight of their debt. But debt is not without value; in many cases, it can dramatically improve your financial outcomes. This article will discuss striking the right balance of debt to avoid over-leveraging.
Are you Overleveraged?
To start off, let’s take a step back and talk about leverage.
When you borrow money, you are “leveraging” the purchasing power of that debt.
You can use it to buy more things than you could have otherwise, and you can use those things to produce more of whatever it is you want.
In an investment setting, you can take out debt to buy financial or business assets. In a personal setting, you can take out debt to buy a boat. In both cases, you are leveraging your way to greater potential returns, whether in the financial or leisure sense.
So what does it mean to overleverage?
Overleveraging means taking out more debt than you can afford. You put yourself at additional risk of default or bankruptcy when you overleverage.
In short, it means you have too much debt.
That would imply that more debt is bad and that you should always strive for less debt.
But it’s not simply a matter of looking at the absolute debt amounts. The type of debt matters.
The type of Debt Matters
Different types have debt have different risks.
Variable rate loans, fixed rate loans, margin loans, real estate loans, and all other loans each carry unique risks. Their potential benefits similarly vary. Let’s go over a few types of debt now.
-Credit Card Debt
Credit card debt is some of the most expensive debt available.
Many people use credit cards for the numerous reward offers out there. They pay off the cards every month and never carry a balance.
But others actually rely on the debt to make purchases that they can’t otherwise afford with cash, whether it be for personal or business spending.
But, with credit card rates often sitting near 20% per year, if not much higher, this is an expensive strategy.
With interest costs so high, credit card debt is a comparatively risky type of debt. If you invest using credit card debt, things need to really go right for it to be worth it.
And if they don’t, those interest costs will continue to mount rapidly.
Margin debt refers to the debt borrowed against a person’s stock holdings. The borrower’s stock holdings are collateral.
You might take out margin debt to amplify your portfolio gains, or to remain liquid without having to actually sell your stocks.
As with any other type of debt, margin loans can also help boost your liquidity, but it’s not without risk. And margin debt has a fairly unique type of risk: margin calls.
A margin call occurs when a lender (usually a brokerage) calls margin debt due.
The debt must be paid off immediately thereafter, though some margin lenders give borrowers a couple of days to make good. But, often, margin lenders do not give much time at all.
This forces the borrower to either add new money to his or her account, or forces the sale of the borrower’s stocks to cover the debt balance.
So if a stock portfolio falls in value too much, the lender can completely liquidate the portfolio to cover the outstanding margin debt.
Margin Call Example: bill hwang’s rise and fall from grace
For an example of how too much margin debt can wipe out an entire fortune, let’s talk about Bill Hwang.
Bill Hwang had a $100 billion portfolio. His net worth was something like $20 billion at its peak.
That means he had around $80 billion in margin debt on his portfolio.
After a rough couple days in the market, his portfolio fell well below his existing margin balance. This triggered a chain reaction of margin calls across the multiple lenders he was using.
Hwang ended up completely broke.
That’s right, Hwang’s $20 billion net worth was vaporized in a practical blink of the eye. All because of a few bad days in the market.
If you’d like to learn more about Bill Hwang’s and Archegos Capital’s collapse, here’s a video I made about it:
Margin debt is no joke.
While it can be used successfully, it can also be ruinous.
-Real Estate Mortgages
Real estate mortgage loans are especially common, though there are many sub-types.
Many mortgages are on a 15-year or a 30-year term, with a low, fixed interest rate.
Others are variable rate, or are fixed only for a certain period of time.
A low, fixed rate loan is going to have different risks compared to a variable rate loan.
For example, a variable rate loan will be subject to interest rate risk, while a fixed rate loan wouldn’t be.
Though, with most real estate loans, the debt is not callable even if the value of the real estate falls.
There are many other types of debt out there.
These types of debt include auto loans, student loans, and many more.
No matter what the debt is for, lenders often can be flexible in creating the terms for that debt.
Those terms are fundamental for determining your risk.
So make sure you understand what you’re getting into and what kind of recourse your lender has.
The Power of Debt
But why use debt at all?
Why not just avoid these risks?
Using debt, or leverage, increases your purchasing power.
You can buy more stocks, more real estate, and more stuff.
That additional stuff can help you to make more money in the meantime. You can supercharge your investing.
When you buy real estate with a loan, you can rent out that property. The income from that property can pay down the loan. And anything left over goes to your pocket as cash flow.
Without the debt, you likely wouldn’t be able to buy the property, and you thus wouldn’t get the cash flow.
That’s one way to avoid the risk of “cash drag” as well.
You’re bringing less to the table yourself but still control the whole asset.
You can see why debt is often so tempting.
should I take the risk?
So, should you take out that loan?
After all, no one wants to be in too much debt.
Here are some questions to ask to help you determine whether you should take the risk:
- What is the type of debt you are taking out?
- Is the debt callable?
- Does the loan have fixed or variable rate interest?
- What happens if the underlying asset falls in value?
- Do you have time to wait out a crash in the asset’s value?
- What happens if you cannot make a payment?
- Do you have cash reserves?
- Do have other income coming in that can cover debt payments?
Overall, it really comes down to understanding the actual risks involved and determining how much risk you are comfortable with.
back to the big question
So, are you over leveraging?
Ultimately, that’s up for you to decide.
But it all starts with understanding your exact debt terms.
Make sure you read the terms of agreement before ever signing a document.
Understand the risk of the underlying investment as well. What would happen if your investment lost value?
Similarly, how much time do you have to wait out volatility?
As soon as you add debt to any situation, you increase your risk.
So tread carefully, always.
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