Leverage is the use of borrowed money to invest.
This type of debt can be a part of your personal financial strategy if you explore it in moderation and use the right tactics. “You don’t want to be overleveraged in any way, shape or form, but leverage in moderation can be a really powerful tool,” says David Mook, chief private banking officer for U.S. Bank Private Wealth Management.
In particular, three types of debt can be used to help you reach your financial goals: liquid asset secured financing, home debt and estate planning debt.
1. Liquid asset secured financing
A liquid asset secured line of credit is like a home equity line of credit (HELOC), except it’s secured by your investment portfolio instead of your home. This allows you to access liquidity without the need to sell assets and incur potential capital gains taxes resulting from the sale of the assets.
“You don’t want to be overleveraged in any way, shape or form, but leverage in moderation can be a really powerful tool.”
David Mook, chief private banking officer for U.S. Bank Private Wealth Management.
Liquid asset secured financing may be a good option for you if you need to generate cash flow quickly. It also offers the benefit of lower-interest rates, as it’s a lower-risk option.
Uses for liquid asset secured financing include:
- Funding special purchases
- Paying a tax bill
- Refinancing higher interest rate debt
If you have a higher risk tolerance, Mook says you can also use liquid asset financing to take advantage of interest rate arbitrage opportunities for investments you think will generate a high rate of return. It’s important to keep in mind, however, that if the investments do not generate the expected returns, losses are increased as a result of the use of leverage.
2. Home debt
A house is an asset on its own, but you can also leverage its equity. You can use money from either a second mortgage or a home equity line of credit (HELOC) to buy a second home, renovate an existing home or purchase a commercial property. Doing so can generate income while also diversifying your portfolio.
Leveraging your home is a higher-risk way to borrow, but for those with a high risk tolerance, the advantages of real estate investments are clear:
- If you believe the real estate will appreciate, you can access liquidity without selling the property and missing out on potential future gains in value
- You may be able to rent out a second property, generating additional income
- Small business owners may be able to use money from a second mortgage to fund their business at a lower rate than what’s available to the business entity
3. Estate planning debt
Contrary to popular belief, debt can facilitate wealth transfer. Two estate planning strategies in particular can help: life insurance policies and grantor retained annuity trusts (GRATs).
Leverage a life insurance policy
Add this as another reason to have life insurance: You can use your policy to help pay for estate taxes after your death. Leveraging your life insurance policy allows the estate to distribute assets at a pace that maximizes the estate’s value.
Mook notes that insurance can be expensive. “If you don’t want to write a large check every year,” he says, “you can finance that premium and use the cash value of the policy or other assets as collateral for the loan.”
Grantor retained annuity trust (GRAT)
A GRAT is an irrevocable trust set up for a short period of time (usually two to five years) that helps transfer assets to beneficiaries in a tax-efficient way. You place assets into the trust and the trust pays you a fixed annuity each year, usually a set percentage of the original amount of assets. Over the life of the GRAT, the assets will inevitably rise and fall in value.
Bank financing could help protect your gains and shield you from losses by allowing you to substitute a stable asset for a high-growth one. For example, substituting cash for stock secures any gains in the stock value to date. If you don’t have the cash to make that substitution, a bank can lend it to you.
When the terms for your GRAT are up, the remaining assets, including any appreciation on the assets, transfer to your beneficiaries tax-free. However, if you’re no longer alive when the GRAT terminates, the assets become part of the estate and subject to estate tax.
Leverage can be a smart financial or investment strategy if you know which tactics will work best for your situation. “We want to give our clients flexibility,” Mook says. “By helping them use leverage, we can make sure they’re able to take advantage of financial opportunities when they become available.”
Learn more about your options for funding life events and major purchases.