Common Cents for July 20, 2012

Is leverage a good thing? In the aftermath of a major financial crisis brought about by ‘too much debt,’ the answer isn’t as clear as it once was. Couple that with Europe’s fiscal unraveling, and you could very easily conclude leverage is a bad thing, or at least something to avoid.

However, debt, in and of itself, is innocuous. The issue is how the borrower uses it. If they take out massive loans to finance consumption or the purchase of depreciating assets, leverage will ultimately have a debilitating effect. If the borrower uses someone else’s money to generate wealth in excess of the interest the lender charges, leverage is a glorious, wonderful thing.

So, again, is leverage a good thing? It all depends on how you use it. To fund fancy dinners and vacations? Well, debt is probably a bad thing there. To start or expand a business? You might be onto something there. Why use your own cash if you can borrow at, say, 4-5% and generate a return of anything north of that?

The trick is for both the borrower and lender to understand the former’s return potential on the borrowed funds. If less than the stated rate of interest, both parties should think twice about the transaction. If more, well, it is a slam dunk, a no brainer. If your assets are growing faster than your liabilities, you have used leverage wisely.

Now, you probably have read something about the “fiscal cliff” the US faces at the end of this calendar year. This is a term Ben Bernanke popularized to describe the end of a multitude of tax breaks and credits, coupled with a decrease in the amount of deficit spending, as agreed upon last summer. Use whatever number you want to use, the upshot is in 2013, if left unaltered, the US consumer will have less discretionary income, and the Treasury won’t spend as much as originally forecast, even if it will still run a massive deficit.

To read more… July 20, 2012 Common Cents