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Debt leverage is a process of creating a balance between debt created and the return that is earned from investments acquired through the creation of that debt. The general idea behind leveraging the debt is to prevent tying up too many resources in the acquisition, while still maximizing the return that is ultimately derived from the investment opportunity. This general strategy is often used when it comes to acquiring real estate by means of using bank loans as the means to finance the purchase.
The best way to understand debt leverage is to consider an example that involves the purchase of a piece of rental property. Rather than using all available resources to purchase the property, the borrower uses a portion of his or her funds to make the down payment on the real estate. The remainder of the purchase price is financed via a mortgage issued by a bank or other financial institution.
Assuming that the loan payments are covered by the monthly rental fees collected from leasing the real estate to tenants, the borrower has created a balance between the revenue earned from the property and the gradual retirement of the debt incurred as part of the property acquisition. Along the way, the borrower builds equity in the property using a debt leverage approach. At the same time, he or she creates a position where additional profits are made if the property is eventually sold at a price that is higher than the initial purchase price. When the tax benefits are factored in, the leverage approach significantly increases the return made on the investment, while using relatively few of the borrower’s resources.
The same general strategy of debt leverage can be used with other types of assets, including the acquisition of stocks. 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 shares are ultimately sold at a profit, the investor not only emerges with the debt repaid 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 using debt leverage as an investment tool is often a good idea, it is important to remember that market volatility can disrupt the process. Should the acquired stock option not perform as anticipated, it may not generate enough of a return to cover the repayment of the loan used to pay for the shares. This will ultimately lead to a loss rather than a profit for the investor, since other assets must be used to retire the debt.
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