Leverage is another method of having your money and/or assets work for you. I am a strong believer in financial leveraging being one of the most important tools for building wealth and I have used it extensively. It involves smartly borrowing money and reallocating the cash to investments that will appreciate in value.
There are pros and cons to this. Using this approach will always increase risk, but depending on the type of financial leverage it could be very minimal. Or some types of leverage, such as buying stocks on margin which I did in the past, can be very risky. We will give examples of low and high risk leverage below. Obviously a higher risk approach will have more cons (negatives) than a low risk form of leverage.
What is leverage?
In its simplest form it is “borrowing” money to purchase an asset in the hopes the asset will increase in value. Most people/readers may stop right there and not read any further as they will say they either can’t or will never borrow money. But really leverage is very common for tens of millions of Americans from all income levels. Many moderate and even low income families also benefit from this concept, as many are homebuyers (maybe through HUD programs), own cars, go to school, or use leverage in ways they may not be aware of.
Ever hear of a mortgage? That is leverage. Or taking out a college loan…that can be considered leverage. Or when faced with an opportunity to buy a car using a loan that is interest free (which still exist from time to time) Those are the most common forms of leverage, but there are others.
Lets walk through an example of home buying. We will keep the amounts simple, not factor in real estate or closing fees, costs of homeownership, etc. Try to follow with us.
Lets say you go to buy a home worth 400K. Most lenders may require 10 to 20% of that price as a down payment, so 40 to 80K. The balance of the purchase price (320 to 360K) will be loaned to you in the form of a mortgage. Now of course you can put down more money if you want and borrow less. The 80K you pay in cash, and 320K you borrow, equates to the 400K purchase price.
Now lets say value of the house goes up by 20% in say 5 years, and you sell it for 480K. At closing the 480K is provided to you by the seller, and say the mortgage balance is at 300K at that time. Out of the 480K, 300K goes to the mortgage holder and the balance of the sale price (180K) goes to you. That means that in 5 years you now have 180K (or 125% return) on your initial 80K down payment. That is leverage..you made 125% on a 20% increase in the real estate price. The funds you put down, plus the money you borrowed, led to a big gain.
But before you get too excited and say that sounds too simple and you will get “rich”, it is to simple. As I learned in life, and has been reinforced even more and more as I age (and over this last year) the devil is in the details in every thing in life.
There is risk in home buying leverage as well. Lets look at the flip side, and the house price went down as happened in 2008-2010 or so. Home prices are also more likely to stay flat and/or not increase rapidly in cities that are already overpriced, such as LA, Seattle, NYC, San Fran, and other coastal cities. Anyhow, the flip side of the mortgage leverage is this.
You pay 80K in cash and take out mortgage of 320K to make the 400K purchase price. But say real estate goes down 10% over 5 years, and you need to sell. So now the house is only worth 360K. You sell, get the 360K and need to pay off the mortgage of 300K or so. This means you only walk away with 60K, so you lost about 30% of your initial investment. That is bad leverage…you lost 30% of your money even though real estate only went down 10%.
Leverage in investments
Leverage also applies to investing. This tends to be higher risk, but it takes into account the magic of compounding, using money smartly, etc. When I was college I started using leverage when investing. I also knew about compounding, and wanted to benefit from that. Examples are as follows.
I took out interest deferred student loans to help pay for school, and used that money as well as income from my jobs and grant money to pay for college. The loans I took out were interest deferred, meaning the interest rate was 0% until after I graduated. So I said to myself if the cost of that money is “zero”, I surely felt I was smart enough to make more than 0% on it. Heck even putting the cash into a CD paying ~2% or so at the time I would have been ahead.
I decided to borrow a little more than I needed, and leverage that student loan, and took a chance and invested it. I invested maybe 30K in loans that I took out from all 4 years of college into the market. It cost me zero percent in interest but I was skilled (lucky!) enough to make 10-20% annually in investments. I maybe turned that 20K borrowed into ~70K in stocks, and then placed that investment into my other portfolio of my stocks that I started since high school.
I also used the same approach to take advance on credit cards and personal loans, and the cards often had “interest free periods” of many months. And the person loans were also very low cost at first….low single digit percent. I leverage all of that into more investments.
What I also did, on top of all that borrowing, is I borrowed even more money on margin from my accounts. This means I took all my stock investments and borrowed against them. This is high risk, especially when using a lot of margin which I did. I borrowed about $3 for every $1 in equity.
Using round examples, if you have 100K in stocks you can borrow 300K from a broker, thereby making your total account worth 400K. And if your investments go up 20% (to 480K), you now have equity worth 180K and the broker still has 300K. So your return on your 100K investment is 80% even though the investments only went up 20%. Leverage…
But once again, if your investments went down 20%, your account is now worth 320K. You only have 20K to your name as the broker still is owed 300K. That is the huge risk to leverage, you would almost be wiped out in this case. And to make matters worse the broker will mostly likely force you to sell (call your loan) as the value goes down…so you are forced to sell at the bottom. While I did not use nearly as much leverage in 2000 dot com bust or 2008 financial crisis, I did have a little and that amplified my financial losses which I mentioned and that I needed to hold in perspective. But then again, I could not have reached 1 million in net equity before turning 25 without leverage.
Anyhow, I was in college borrowing on margin. I was borrowing several hundreds of thousands of dollars from brokers. I even margined against the student loan money. It was high risk to say the least, and looking back I have no idea how I did it. I think my thought/approach at the time was something along the lines of while I am low key, introvert, very much dislike attention, I do have an interior fire and extreme confidence. Even now I do not like attention (which I am trying to make peace with and overcome a little) but I do write about these things.
I recall thinking even if I blew all that money, went into debt from blowing the student loan money, etc. I knew I would be able to pay it back over the years…as I knew my drive, fire, fear of failure, drive, I would find another business opportunity or make it up I in the corporate world. I think I justified the risk of leverage from that.
If only my acquaintances/friends and roommates knew what I was doing at 5 in the morning in front of my computer with dial up modem service…reading stock reports, prepping investments, getting ready to place orders worth tens or hundreds of K, etc. Ha!
Long story short, leveraging is smart. Buying a home is leverage. Investing in an education in pursuit of a higher paying job is leverage. If a car dealer offers 0% or super low rate loan for the purchase of a car, borrowing the full value of the car instead of making a down payment is leverage (providing you invest that money). Think about the cost of debt/loans, and if the rates are low enough or zero, then borrowing and using the money to invest…that is leverage.
But be smart about it, think it through, and read up more on this approach. As anyone who buys a home or say a car, (whether you are low income or wealthy) should understand the concept a little more, as they are using leverage. It also applies to other aspects of life for people of all income levels. Some leverage is very, very high risk with tremendous downside. But doing it smartly (and with maybe a little luck) can build wealth…doing it foolishly can lead to, in some cases, financial ruin.