Leverage

Bob needs to mow the lawn. Mowing the lawn takes 1 hour of Bob’s time. Bob is very careful about his time, which can be sorted into the following categories: work time, leisure time (spending time with family, running, sleeping, etc), and time for chores (like mowing the lawn!).

Usually, Bob allocates one hour per week to lawn mowing. But this week he decides to do something different. Instead of mowing, Bob decides to use the hour to go shopping for a better lawn mower that can mow the lawn in half the time. This is great, because now Bob will have an extra half hour of time each week for leisure, or something else. What’s not great is that the lawn is now overgrown and will take 1.5 times longer to mow next week. Additionally, Bob has to pay for the lawn mower by working for an extra hour. So in week 2, Bob spends 45 minutes of the normal hour mowing the lawn, leaving him 15 minutes of extra time. He uses this plus 45 minutes of leisure time to work and pay off the lawn mower. So Bob is in a time debt of 45 minutes.

But the next week, Bob can make up 30 of those minutes thanks to the new lawn mower, and then the week after that Bob is in a time surplus. After that, Bob is gaining 30 min of time every single week. He can use this time to have fun, or do more work which will make more money, which he can invest, and thus greatly increase his ability to have a whole lot of leisure time in the future.

Let’s consider an alternative outcome. Let’s say Bob bought the lawn mower in week 1, but had something unexpected come up in week 2 that took up a lot of his time. Now Bob’s in trouble, because he was supposed to spend 45 minutes mowing and an hour working. Things are overgrown. The neighbors are getting angry. The whole neighborhood is suddenly losing its luster. Bob now has to hire someone to finish mowing his lawn. On top of that, he has to pay extra because the overgrown lawn is more difficult to mow. In the end, it’s going to cost him several more hours of work time. And if this happens on any sort of regular basis, Bob is going to start having trouble finding time to mow the lawn at all and keep having to hire people to do it, ultimately adding many hours, weeks, months, or years of work time, thus ruining Bob’s life.

This is my not so great attempt to conceptualize leverage, where debt is taken on in order to acquire additional assets1Thanks, Google!In this case, Bob took on debt in the form of time and money in order to gain an asset (the lawn mower) which produced more free time and/or money in the future. Leverage can be a powerful tool when everything is peachy, like in the first scenario. But it can also backfire in a major way if it’s taken on in a risky way. Let’s talk about a couple quick examples.

Say you pay your electric bill by check. Then you switch to credit card. All of a sudden you don’t actually pay the bill until a month later, after you’ve gotten your next paycheck. So what, you say, you’ll still eventually have to pay all your electric bills. You’re essentially trading not paying an electric bill now with paying an extra electric bill after you’re done using electricity in the future2Ok, this was probably not a great example cause you’ll keep on using electricity forever, but stick with me!. But the money you saved in the first month can be invested and compound over the months or years or decades until you get your “final” electric bill. At that point, you’ll have so much money from the first electric bill that you delayed paying that you’ll be able to cover the last electric bill and have a lot left over. But let’s say in month 2 the electric company decides no more credit card payments. Now you’re stuck paying for two electric bills in one month. And if you already spent the money you “saved” in the first month and are barely scraping by you could be in trouble.

Another example of leverage that people use all the time is the mortgage. Say you buy a $200k home and put $20k down. Then, the value of your home instantly goes up by $20k. Now, if you want, you can sell your home and realize your 100% return (you sell for 220k, pay off your 180k loan, and end up with 40k from a 20k investment). But if the opposite happened, you’ve automatically lost 100% of your investment even though the actual value of the house only dropped by 10 percent.

This is all overly simplified, but just meant to get you thinking about how leverage works, and what the positives and drawbacks are. As a general rule, it’s pretty risky and in most cases not recommended. Buying a house is a common exception, because real estate prices tend not to have wild fluctuations (but this can happen) and generally rise with inflation. Although you can see why planning to buy and sell within a few months or even years can be quite risky.

In the words of friend and guest-poster Ryan, “A simplistic rule is that going into debt for nonproductive consumption is bad and going into debt for a productive asset can sometimes be good, but not always (leverage amplifies risk so it should be used sparingly)”. For example, taking on debt to get an education is productive and mostly likely good. So is using a credit card to earn rewards when you pay your balance in full each month. Or investing in a faster computer if you do a lot of work on the computer. On the other hand, using a loan to pay for entertainment or leasing a car is almost definitely a poor use of leverage.

2 response to "Leverage"

  1. By: Alex Posted: September 29, 2019

    Are we talking a push mower or a driving one?

    • By: Joey Posted: September 29, 2019

      The first one was definitely a push mower. The second one was maybe a driving one :). I thought about making it so that he mows his neighbor’s lawn for money or rents his fancy mower out or something, but the story had already been revised many times haha.

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