Most people consider debt as a financial hindrance — an obligation instead of an opportunity. But knowing how to leverage debt to earn profits can be one of the most vital skills an investor can have.
The secret to leveraging debt is using it to acquire income-generating or appreciating assets. With patience, a close eye on risk management, and sticking to repayment terms, it’s entirely possible to earn profits.
In this post, Gorilla Trades breaks down how to leverage debt in three common scenarios. We’ll also discuss good debt vs. bad debt, provide strategies for debt management, and offer some real-world examples of the risks and rewards of smart borrowing.
What Does It Mean to Manage Debt?
Leveraging debt means using borrowed money to increase your investment potential. Rather than relying on your existing wealth for capital, you strategically deploy credit lines and loans to boost the chances of a profitable return on investments. This concept is known as financial leverage.
Successful debt management requires discipline. It doesn’t mean taking unnecessary or hasty risks that come from bad planning. It’s a deliberate, strategic use of borrowed capital to pursue strong opportunities for profit. With a close eye on risk mitigation and repayment efficiency, you can use other parties’ money to control larger assets. You can increase your investment exposure to earn compound returns over time.
Here are three established ways investors can leverage debt to gain wealth while managing risk.
Real Estate Investing
Real estate is a classic way for investors to leverage debt. To some extent, anyone who takes out a mortgage on a home or property leverages debt in hopes that their asset will appreciate. More ambitious investors, though, can eye profits through strategic real estate investing.
Owning a rental property is one such strategy. The buyer pays for a rental property with only a little bit of their own capital, and the bank funds the balance. As the property appreciates, rental income from tenants gradually pays off the loan.
Here’s an example. You buy a rental home for $300,000. You use $50,000 for a down payment and finance the rest through a lender. You hold on to the property for several years and charge rental rates in line with cost-of-living increases. After 10 years, your property appreciates to $400,000 while rental income pays off your mortgage. You’ve gained $100,000 in equity and earned passive income — all from owning an asset six times larger than your initial capital.
Some additional considerations are important to think about. Interest rates play a major part in your earning potential. You can opt for the more stable fixed rate or adopt adjustable rates that can fluctuate with the market. Also, your rental income should surpass the value of your mortgage payments, applicable taxes, insurance, and maintenance expenses.
With careful debt management, many investors have built great net worth through real estate investing and rising property values.
Business Loans
Many self-made entrepreneurs use business loans to fund expansion, such as opening additional locations, purchasing and upgrading equipment, or ramping up marketing efforts.
For example, suppose that you’ve owned a local coffee shop for a couple of years. You’ve tapped the market correctly, made a superior product, benefited from word of mouth, and maintained a loyal customer base. You believe you’re in a position to expand, so you borrow $100,000 to open a second location across town.
You bring your business sense to the new location, where it works just as well as it has in the first shop. Within 18 months, your new branch has gone into the black, doubling your revenue and boosting your business’s value. This is a textbook example of financial leverage — you’ve managed your debt to earn much more income than the cost of your loan.
Success in this kind of venture hinges on strong debt management. Calculate how much you expect in returns before borrowing the loan. Try to align loan repayments with annual cash flow patterns — some seasons are more profitable than others. Keep your credit record in good shape so you can get favorable terms.
Margin Trading
Margin trading is one of the higher-profile debt leverage strategies out there, having been depicted in Hollywood movies like Margin Call and The Big Short. The truth is that movie studios don’t make films about safe, low-risk investments with predictable returns. There’s great risk involved. But with a highly disciplined mindset and extra caution, buying on margin can be a successful way to leverage debt.
In margin trading, you borrow funds from your brokerage to buy more shares than you could with your personal cash reserves. Margin movement can result in significant returns, but again, your risk could be elevated.
For example, suppose that you have $10,000 in hand and use a 2:1 margin to buy $20,000 in stock. If the stock value goes up by 10%, your gains double, and you get a 20% return on your cash. However, if the stock price declines by 10%, you’ll lose $2,000, or 20% of your original investment.
Because of its potential for risk, margin trading requires an extra amount of self-discipline and caution. Use margin calculations only for high-conviction, low-volatility positions. To prevent excessive downside, set stop-loss limits for exiting positions before you lose too much. Commit to extensive research on your prospects, and be crystal clear on your brokerage’s rules regarding margin calls.
Good Debt vs. Bad Debt
Yes, there actually is such a thing as “good debt.” But as way too many adults have learned, there’s also a lot of bad debt. It’s important to know the difference. It comes down to future revenue generation.
“Good debt” is used to get assets that will appreciate in value. It can be combined with income streams like rent or revenue from customers to increase profits. Common examples of good debt include mortgages on income-earning properties and business loans for expansion. They may even include student loans, if your career results in strong returns on investment (ROI).
“Bad debt” finances depreciating assets and products that are instantly consumed with no tangible returns. This includes excessively high-interest credit debt and personal loans for luxury items or short-term gratification.
This doesn’t mean you should never finance a well-earned vacation or the occasional ribeye steak. But with any expensive investment, it’s critical to ask if it is a means to building future wealth. If it isn’t, practice extra discernment.
How to Leverage Debt: Best Practices in Management
To leverage debt effectively, keep a few important strategies in mind:
Borrow Within Your Means
Don’t take out more than you can afford to pay back in regular installments. Factor in your expected income or revenue.
Opt for Favorable Interest Rates
Interest charges can compound as easily as interest earnings, so choose the rate that’s best for your venture. Fixed rates are great for predictability, while variable rates could sharply rise, especially in unstable markets.
Set Up an Emergency Fund
Expecting the unexpected is always a good approach. Build up a savings or brokerage account for emergencies, so if your income stream gets disrupted, you can still make debt payments.
Diversify Your Leverage
Portfolio diversification mitigates investment risks. In much the same way, using borrowed funds to invest in a wide range of asset types — real estate, stocks, bonds, and others — can make risk management and debt leverage much easier.
Use Debt Leverage the Right Way
Knowing how to leverage debt is all about maintaining responsible management and discipline, as opposed to reckless and over-speculative borrowing. Mastering debt repayment while attentively monitoring earnings and interest is one of the most valuable traits a smart investor can develop.
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