Leverage and the Debt-to-Equity Ratio

Leverage and the Debt-to-Equity Ratio

Once again, please join guest blogger Mitchell Pauly for a fun, funny and informative take on finance definitions!

Think back to mid-2008 when the financial turmoil in America was spreading like a bad joke throughout the rest of the world: seemingly everyone was underwater in their mortgage. The water couldn’t have been that nice. We all understand now that one of the main causes of that meltdown was the average American borrowing more than they could afford to pay back — that is, they were over-leveraged.

Leverage is Important

Being over-leveraged involved leverage, or borrowed money, used to purchase an asset like a house. Think of a wrench with a short handle and one with a long handle trying to turn a bolt; the long handle creates the leverage needed to complete the task with ease. In 2008, that long handle temporarily broke.

Our economy depends on leverage to function like a diabetic depends on insulin. Not many people can afford to pay cash for a house, and not many businesses can pay cash for a production plant or office. No leverage, no economy. When one is over-leveraged it means they do not have the means to pay back the loan. The consequences of this are obvious.

The Debt-to-Equity Ratio

You will never hear of someone being under-leveraged. These people are the gold-star pupils of personal finance. But how to best determine if one is under- or over-leveraged? The debt-to-equity ratio, that’s how. An exciting part about this ratio is that it is easy to calculate (you may sigh in relief). Simply take all your debt (borrowed money, like credit card balances, mortgage, car loans, etc.), all of your equity (here defined as cash and items you could sell for cash), and divide the debt by the equity.

A quick note: for items you are paying off, like a house, you must split the value of the asset into the balance you still owe (debt) and the portion you have paid for (equity). Any number over one means that you have more debt than equity**.

The Connection: Leverage and the Debt-to-Equity Ratio

Leverage is a good thing so long as we keep our debt-to-equity ratio as low as possible. Leverage allows us to raise our children in safe homes, purchase newer, safer cars, or get out of a financial bind if needed. It’s when folks over-leverage their lives that issues usually arise, usually because the payments on the debt exceed the cash available.

A great way to monitor your leverage is to track your debt-to-equity ratio. You would be insane to recalculate every time you use your credit card, but loosely tracking your ratio may be a tremendous help when you consider large debt-related events, like a home purchase. In time, you will be able to calculate the ratio in your head, testing the water before you jump in.

**Having a number over one doesn’t mean you are a financial loser, so chin up, kid. Most people in the first half or their mortgage period have a debt-to-equity ratio over one. If you do not have a mortgage and still have a number over one, you got some ‘splainin’ to do.

Mitchell Pauly is a Financial Professional with experience working for Fortune 500 companies and small businesses. He enjoys investing and personal finance, comedy and sports. In his spare time he writes for various publications about personal finance, with a mind towards young adults and parents of young adults.

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retirebyforty's picture

retirebyforty wrote:

Mon, 09/19/2011 - 23:32 Comment #: 1

I'm a bit confused about the house.
Let's say it's worth 150k and I have 100k mortgage on it.
The debt to equity ratio is 2:1 then? 100K/50k

Christa Palm's picture

Christa Palm wrote:

Tue, 09/20/2011 - 19:39 Comment #: 2

RetireByForty, yes you are right. Thanks for the clarification!

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Financial Definitions: Interest Coverage Ratio | MomVesting wrote:

Mon, 10/31/2011 - 11:15 Comment #: 3

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