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Bad Debt and Gray Debt: Leverage

A lot of bloggers have recently posted about Good Debt Versus Bad Debt. So goes the saying that leverage can lead to higher returns. In a simplistic way they have a point, leverage can be good. However, debt for the purposes of goosing your returns is a bit of a gray area, or Gray Debt as the title of this post alludes. I will write today in the hopes that this information will help you decide on your relationship with debt.

What is Gray Debt?

The basic premise of Gray Debt as a positive is it allows you to earn a return on money that you have not necessarily earned. So, if I have 100K in mortgage, that is 100K in assets I have yet to earn the specific 100K to purchase. Sure you might have 100K sitting in an investment fund allocated for that purpose, but until you use it effectively you have your net worth plus 100K in assets earning you income.

Now, if you were paying more in interest for your loan then your extra 100K in assets returned, we would still be talking about bad debt. You would have a net impact on your finances over time. However, if over time you earned more from that 100K asset then the 100K loan cost you in interest, you have multiplied your income using leverage. Sounds simple, but is it?

How to Create Gray Debt

Let’s start with a simple question. What type of loans would create this leverage situation? We named one already in a mortgage. However, would a 0 percent car loan? Well it depends on if you paid more for the car to get 0 percent. That question is admittedly outside the scope of this post, but it is something to consider. Is taking a loan versus paying cash costing you more in a raised price? It is easy to not consider this point when taking on leverage to goose your returns. We bought a car back in 2015 at 0 percent, but before we did we weighed the difference in a cash negotiation against our expected interest returns. Ultimately our fixed income returns ended up just a slight bit ahead so we went with the loan. However, it is important to check.

Would a student loan? Well does your investment exceed the interest rate of the loan?

Time, Risk, and Gray Debt

We can establish the criteria that the investment has to exceed the loan interest rate, but over what time period? The stock market ebbs and flows but has a historical return in the 6-7% ratio. How long those ebbs last is extremely variable. It could be 1 week, 1 year, or even 10 years. So if you are taking a mortgage and investing it in the market it is hard to tell if you’re creating leverage or costing yourself money. The longer the mortgage the more likely you are to earn a positive return.  However, it is still not 100 percent. This is the risk of leverage. It tends to bring more risk to the situation. Returns are of course goosed but there is no free lunch. The risk is instead of essentially eliminating a fixed interest rate debt that offsets any fix rate return you might have, you might end up with a variable rate market return that decreases the value of your portfolio in addition to that fixed interest rate cost.

Which brings us back to our good friend risk tolerance. Gray Debt increases your risk. You need to know if you can handle that risk as not being able to will decrease your likelihood of obtaining the needed return . If you pull all of your investments out of the market after it tanks, then you were probably better off paying off the “Good Debt” instrument.

Liquidity and Gray Debt

An additional point to consider is your liquidity. Can you afford to pay the payment on the loan without tapping your other investments? What if you lost your job would you still be able too? This is exactly what happened to real estate speculators during 2008. They bought huge numbers of houses using high amounts of debt. Essentially they used the equity of the first house to buy a second house, and so on and so forth until their leverage was sky high. Then the market collapsed, both from a job perspective and from a real estate price perspective. They could no longer pay for the next house out of their job income or from a future loan used on the next house. Figuratively the house of cards came crashing down.

Gray Debt and History

Lest you think this is a unique event I recently finished reading a book about the 1929 Great Depression. The book “The Great Crash 1929”, by John Galbraith talks about the causes of the great depression. Chief among them was the usage of leverage. At the time there were market investments called investment trusts. These were not unlike Mutual Funds in some ways, but like hedge funds in others. Essentially banks would buy shares on the market. They would then sell shares of this fund to a subsidiary.  The subsidiaries investment was actually the money source for those initial shares. They would then sell shares in the subsidiary to the another entity at a markup which would provide the money to the subsidiary. On and on it would go until the customer at the end purchased the shares of the final trust. Essentially they created leverage at a time when such a thing was not otherwise allowed. The market of course tanked and these large investment trusts went under taking their investors with them.

Which leads to another point. Do you understand how much leverage already exists in your accounts? Are your investments (hedge funds if you’re so inclined but very occasionally for specific exceptions mutual funds) using leverage? What about the individual company whose stock you bought? Are they leveraging debt on their balance sheet heavily to subsidize growth? All this risk is cumulative and something to keep in mind.

Conclusions Regarding Gray Debt

The implication here is gray debt should be employed only if you have sufficient assets and emergency fund to pay the underlieing debt if the proverbial #@$^ hits the fan. Also, you need to go in to the decision with eyes wide open that you are taking on more risk. You could be cool with that, some people are. It is however important for you to consider the ramifications before leaping.

Do you employ leverage in your investing? Do you use Gray Debt to get ahead?

If you have interest in Galbraith’s book I can highly recommend it.  I have included an affiliate link above available by clicking the book title for those that are interested.  Should you decide to purchase I will receive some renumeration from Amazon.


  1. Erik @ The Mastermind Within
    Erik @ The Mastermind Within February 20, 2017

    I have a rental property and since I have a mortgage, I have leverage in my portfolio. I think about investing using options or different investments in the market, but haven’t ventured into that area.

    I don’t think it’s safe to use leverage unless the asset has value and has shown the ability to hold value over time (house is a great example).

    • February 20, 2017

      I agree, the long term viability of the investment asset is important in the decisions to use leverage. We currently utilize leverage both in the aforementioned 0 percent loan and our mortgage.

  2. Mustard Seed Money
    Mustard Seed Money February 20, 2017

    I have to admit that I don’t use any debt leverage right now. There haven’t been any investments that I have seen that make sense for me to employ it yet. I am also a bit risk adverse so I have to almost have a guarantee before I would employ the strategy. But I have heard of some people that employed it and have done very well for themselves.

    • February 20, 2017

      Risk levels depend a lot on the person. It’s good that you know your tolerance level. My main current usage of leverage is primarily that 0 percent car loan I referenced. The cash for it currently sits in my emergency fund cd ladder, FDIC insured CDs. So in a lot of ways we have the same risk tolerance.

  3. Lars-Christian
    Lars-Christian February 20, 2017

    I’m currently only utilising leverage in the form of a mortgage to finance a house (for which I paid down exactly zero, but that’s a topic for another day), but generally I’m a big proponent of using leverage to increase your potential returns. That is in stark contrast to most people who blog about personal finance out there, of course 🙂 The key is being conscious about the risk you are assuming, and whether or not it fits in with your overall risk profile.

    Depending on how my situation develops, I can easily see myself taking advantage of cheap debt to finance investment opportunities. Generally speaking, I think the current climate with all time low (albeit rising) rates have made it very favourable to take advantage of debt to finance an investment you believe in.

    • February 20, 2017

      Some people are more risk tolerant then others. As long as you know your tolerance and understand the risks then I see nothing wrong with your approach.

  4. Mr. Zero
    Mr. Zero February 20, 2017

    The only leverage I employ now is a small mortgage on my home in the US. The home is located in an area where home appreciation has been negligible since I bought it in 2005. At this point, I would count myself lucky if the appreciation is enough to pay for the home maintenance and cost to sell. So in terms of grey and bad debt, this mortgage is definitely bad debt, but some special circumstances with my expat assignment package with my company make it a no brainer to maintain a mortgage until my assignment comes to an end. So my plan is to pay down the remaining mortgage to a point where the regular monthly payments will pay off the house right as we plan to repatriate.

    I have read stories of people that took out 2nd mortgages on their homes during the 2008/2009 recession and piled the funds into the market. I am sure they came out smelling like roses, but there is no way I would have the guts to do something like that. Way too much risk for this Zero.

    • February 20, 2017

      You should write a bit on your blog about personal finance and the Expat life. I’d be interested in reading about it. We have come very close at 2 separate times to assignments in Australia or Singapore. So far it has not happened.

      • Mr. Zero
        Mr. Zero February 22, 2017

        I am actually working on one now – A little expat fun and finance around transportation options. We are in Year 7 of a planned 9 years on assignment in Asia. If you get the opportunity, all I can say is go for it. While it can be stressful and does require some sacrifices, It has been a life changing positive experience for us.

  5. SMM
    SMM February 21, 2017

    “Ultimately our fixed income returns ended up just a slight bit ahead so we went with the loan. However, it is important to check”

    This is the reason why I got a car loan. It was so cheap to get and I’d be better off with it than paying off the car outright and not having the cash available to invest in something with a better return. Of course I could have bought a car so cheap that paying it off wouldn’t do hardly anything to my cash position, but……that’s a different story, 🙂

    • February 21, 2017

      Very true, buying a cheaper car is definitely something to consider. But if you are doing it anyway you might as well use the loan for leverage.

  6. SomeRandomGuyOnline
    SomeRandomGuyOnline February 24, 2017

    Same here… have leverage in our mortgage. I just hate debt in general (personal thing), but so far the math is winning out and I’m tolerant of the mortgage, at least for the time being.

    • February 24, 2017

      Sometimes you have to fight your instincts with math. Other times the gut wins. I suspect a large portion of the personal finance community struggles with the same tendency.

  7. Leo T. Ly @
    Leo T. Ly @ March 1, 2017

    I do use grey debt to improve my returns. However, I always assess my leverage situation to ensure that I can handle it. When you use leverage, it’s important to manage risk and not be too greedy and leave some room for error.

    • March 1, 2017

      Not being too greedy is an often underlooked point. It’s easy once the returns start flowing to feel like a genius and keep piling on leverage. In the Galbraith book I referenced it talks about how revered those who were running the investment trusts were, up until the point where the rug came out. Inside all of us that same perception tends to ring true.

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