Debt leverage is a strategy of balancing debt and investment returns, often used in real estate purchases. By using a portion of their own funds and financing the rest with a mortgage, the borrower can accumulate equity and potentially profit from the property’s sale. This strategy can also be used for buying equity, but market volatility can disrupt the process.
Debt leverage is a process of creating a balance between the debt created and the return that is earned from the investments acquired through the creation of that debt. The general idea behind debt leverage is to avoid tying up too many resources in the acquisition, while maximizing the return ultimately derived from the investment opportunity. This general strategy is often used when it comes to acquiring real estate by using bank loans as a means of financing the purchase.
The best way to understand debt leverage is to consider an example involving the purchase of a rental property. Instead of using all available resources to purchase the property, the borrower uses a portion of the borrower’s funds to make a down payment on the real estate. The remainder of the purchase price is financed by a mortgage issued by a bank or other financial institution.
Assuming that the loan payments are covered by the monthly rental fees collected by leasing real property to the tenants, the borrower has created a balance between the income earned from the property and the gradual retirement of the debt incurred as part of the property acquisition. Along the way, the borrower accumulates equity in the home using a debt leverage approach. At the same time, he or she creates a position where additional profit is made if the property ultimately sells for a price that is higher than the initial purchase price. When tax benefits are taken into account, the leveraged approach significantly increases the return on investment, while using relatively few borrower resources.
The same general debt leverage strategy can be used with other types of assets, including buying equity. As long as the returns are sufficient to cover the debt incurred as part of the acquisition process, the investor has a balanced position. When the stock is ultimately sold at a profit, the investor not only emerges with the debt paid in full, but has a profit to show for the effort that would not be possible without the use of a debt leverage approach.
While debt leverage as an investment tool is often a good idea, it’s important to remember that market volatility can disrupt the process. If the stock option does not work out as expected, it may not generate a sufficient return to cover repayment of the loan used to pay for the shares. Ultimately, this will lead to a loss rather than a gain for the investor, as other assets must be used to pay off the debt.
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