Leverage (or debt) has become an integral aspect of our society and learning to use it effectively is essential to almost any individual’s financial well-being.

Consider for a moment the pervasiveness of leverage in the economy. The U.S. government relies on debt to support its daily operations, and only a fraction of corporations operate without applying debt to their balance sheets. Similarly, home ownership, higher education and even basic consumer goods are often beyond the grasp of ordinary individuals without the use of loans or credit cards.

Regardless of where you look in our economy, leverage is there in one form or another. It is a tool — the financial equivalent of a double-edged sword — that must be wielded with wisdom and prudence. In this article, we will look at home ownership, investing and lifestyle leverage and show you how to stay debt-free in a debt-filled world.

1. Leverage and Home Ownership

One of the least considered forms of leverage for individuals is the home loan, or mortgage. From a psychological standpoint, most individuals perceive a home loan as being just another cost of living overlaid with the benefits of long-term increases in the value of real estate. This is generally true over long periods of time, but the reality is that a home loan represents a highly levered real estate investment. For example:

• If you provide a 20% down payment for the purchase of your home, you are actually taking a 5:1 levered position
• If you do an FHA loan with a 3% down payment, this equates to approximately a 33:1 levered position

Like it or not, a home is like any other investment: it can go up or down in value. By leveraging this investment anywhere from 5:1 to 33:1 you are introducing substantial volatility to your overall net worth should you be forced to sell your home due to unforeseen circumstances. (To learn more, see Investing In Real Estate . Home-Equity Loans: The Costs and the Mortgage Basics tutorial.)

Leverage and Home Ownership Example

To illustrate, consider the following table that describes how a 5% realized loss on a home would affect the value of your down payment (or home equity ).

As you can see in Figure 1, a 5% loss can be substantially magnified by leverage and manifest itself in a loss as small as 25% of home equity, or a loss well in excess of your original investment.