Debt, it’s something that can make or break you. Almost every American uses leverage to buy their homes, to buy a car, and many use it to buy consumer items. Many millionaires have used leverage to build their wealth. More likely, however, you are aware of the stories of men and women who bet it all and lost. Leverage has taken down men like Ben Graham, Warren Buffett’s mentor, when he utilized debt while investing during the eve of the great depression wiping him out. On the other hand, Warren Buffett was able to use leverage in the form of insurance float to juice his own returns shooting him to the stratosphere in terms of wealth. If you are going to be using leverage in life, always try to make sure that you are intelligent in its use, and that you limit the potential losses.
How I think of Using Leverage in Life
I generally prefer to think of using leverage as a spectrum based on risk. On one side, you have individual development accounts which allow people with moderate income to save money and achieve a three or four to one match based on the money you save. Since there are no repayments, the leverage gained by using these accounts is critical for you to use if you qualify for these programs. On the other hand, for me, are ideas like using student loans to invest. For me, those ideas are extremely risky since the US made it almost impossible to discharge those loans in bankruptcy. What is the point of using leverage if everything goes to hell, but you can’t get rid of the debt in court? There are smart and intelligent ways to use leverage and debt, but investing with student loans isn’t one of them unless you absolutely know what you are doing, and even then that is something I would be extremely hesitant to use.
Another part of using leverage is that you have to know what your skills are. If you are interested in real estate and generating a lot of passive income through rent, you may want to consider something like an FHA 223 loan. These loans allow an investor to buy multi-family units like apartments for better rates since they are government insured to try to help protect lenders. Under some circumstances the investor will be able to get one of these loans for only 17% to as low as 10% down. Where the risk comes are the skills the investor has. If the investor has great people skill, good operating abilities to make sure the building is well maintained, the location is favorable, and has marketing talent, she can turn this into a goldmine. If the investor has none of the above skills, she may have the worst time of her life and be driven into bankruptcy. One person using leverage in life through this loan to get passive income has far less risk than someone else. It all comes down to the skills that you have in your life. (Please note I have no fiduciary duty to you, and any actions you take are completely on you. This is using current loan structures from the FHA as an example for this post.)
Using Leverage While Investing
To be completely honest, I have never used a margin account. I have never bought a single option or derivative, or used any form of debt available to investors. That doesn’t mean I don’t think there are intelligent uses that one can use in a margin account. It’s just that for me I prefer not to be tempted by margin debt, and later a call is issued, and all of a sudden I’m in bankruptcy court. Others can find intelligent techniques that can minimize taxes, increase their investment gains, and a host of other things a margin account allows you to do. Once again everything comes down to the skills and temperament you possess. Some people can make a killing off of what a margin account allows, some can’t. The point of life is to maximize the great cards you get while minimizing the downside on the bad.
Some Final Thoughts on Using Leverage in Life
There are going to be points in life where using leverage will make sense. If you are working in Burger King on minimum wage, you need to participate in an individual development account. Those are some of the best things ever introduced for the poor and lower middle class this country has brought forth. Getting an almost free three or four thousand dollars you can use to pay your student loans or buy a house is a gift you shouldn’t look over. Always be looking for these opportunities in life because there is zero risk attached. For the vast majority of cases where you will use leverage, unfortunately, there is risk. This is where Warren Buffett and Charlie Munger talk about knowing your circle of competence. For some, an idea is a great risk adjusted opportunity, for others that same opportunity is a black hole that will tear you asunder. Be brutally honest with yourself, and look at the products and ideas that you have a particular advantage in, and when the stars align take your swing.