Debt, Leverage, and the Cost of Money

Debt, Leverage, and the Cost of Money Debt is so common in the modern economy. Everything is constantly being financed, from your mortgage to car loans to credit cards—even the very currencies we use as money (see my earlier article on currency). But to truly understand debt and how and why it’s used, we must first understand the concept of leverage. Leverage: The Financial Fulcrum Leverage is a pretty simple idea commonly taught in beginner physics: utilizing a smaller amount of force to move a significantly bigger amount of mass using a lever. The main idea is that you are trading force for distance. You are able to use less strength over a greater distance to move a heavy mass. Let’s apply this idea to finance. We’ll use an example to show how we use debt as leverage (the lever) to “move the mass,” which in this case will be buying a house. • Scenario 1 (No Leverage): Joe buys a house for $100,000 in cash as an investment. Three years later, the value of the house goes up to $110,000. He made a $10,000 profit, giving him a flat 10% return on investment. • Scenario 2 (With Leverage): Joe only has $20,000. He borrows $80,000 at 5% interest to buy that same house. Three years later, the house is worth $110,000. He pays back the loan plus interest (which totals $84,000). From his $110,000 sale, he is left with $26,000. On his initial $20,000 capital, that $6,000 profit is a massive 30% return on investment. We just showed how debt can be effectively used as leverage, allowing you to create a bigger return on smaller amounts of capital. But, of course, it’s not all sunshine and rainbows. What if the house went down in value to $90,000? In Scenario 1, you just lose $10,000 (a 10% loss). But in Scenario 2, after you are forced to sell the house at $90,000, you still have to pay back the $84,000 loan. You are left with just $6,000 from your original $20,000. That is a devastating 70% loss. Debt is a high-risk, high-reward strategy. But how is this risk calculated? The person lending Joe the $80,000 (let’s call him Peter) knows that if the house drops in value, Joe might not be able to pay him back. That’s why Peter charges an interest rate. It adjusts for the riskiness of the loan and gives Peter a profit incentive. To fully grasp exactly how these numbers are decided, we must dive into how the very value of money is calculated. The Time Value of Money A dollar today is worth more than a dollar tomorrow. Why? Because a dollar today can be used to invest in something that generates returns—whether that’s starting a business, investing, or even just buying yourself a new coat that provides immediate value. To calculate the value of that money across time, we use two core formulas. (Note: For simplicity’s sake, we are not adding inflation into the calculation just yet, but you would simply plug those numbers into the equation). 1. Future Value (FV): Answers the question, if I invest money today, what will it be worth later? $$FV = PV \time