Many Americans today have a skewed view of debt, seeing it as something to be avoided at all costs. In turn, they’re spending all of their extra cash on reducing debt rather than a more conservative approach to debt reduction. However owning your assets “free and clear” isn’t always the best option.
This is because of the power of leverage.
“Free and Clear” is a Myth
Interest has become such a hot-button word that people let it control their lives. The myth is that without debt, you can maximize your money by avoiding interest payments. People have become conditioned to think that all debt is bad. However in the circles of the wealthy, that is not how the world operates.
- Do the wealthy start business ventures in which they refuse the help of any outside dollars and grow their business slowly?
- Do successful real estate investors save up to buy all of their properties in cash?
- Do the wealthy keep their money in cash, or do they put it back to work so they can generate new wealth?
The wealthy have learned the power of leverage—how to use their assets to obtain more assets. It’s a calculated process, and in turn it allows them to build monthly cash flow over stagnant cash. To them, debt is a tool to building greater certainty in their own lives. And it’s accessible to you, too.
The Power of Leverage
Leverage is the 12th Principle of Prosperity. It helps you increase the movement of your dollars through your assets. It also allows your dollars to do multiple jobs, and when that happens you can increase your cash flow.
Leverage also gives you access to deals you might not otherwise have. It’s infinitely more difficult to get started in real estate, or really any investment, without leverage. You may not be able to drop $100,000 or even $200,000 on a property, however $10-$20k is much more attainable.
This is because savings alone can take years to build, while leveraging what you have can yield positive results right away.
Here are three reasons you may WANT to leverage your assets.
1. Financial flexibility
Without flexibility, investors often end up dividing up their money in ways that actually make their money inefficient, inaccessible, or both. They attempt to fund qualified retirement plans, investment portfolios, savings accounts, and pay of all their debt too.
The result is too many accounts and not enough money. And although you want diversification, the reason you want it is for accessibility and cash flow. That’s where leverage comes in.
Ample savings give you certainty that you can weather the unexpected, yet who can afford to have all that cash earning next to nothing? Whole life insurance acts as a vehicle for savings AND a leverageable asset, so that you don’t have to drain your account in an emergency or opportunity.
Instead, you could borrow against your value (or collateralize with the bank) to finance a new car, get into real estate, send your child to college, or start a business. And your cash value is still growing.
2. Increased cash flow
Having leverage can not only make certain opportunities possible, it can make good investments even better. When acquiring a cash-flowing property, nothing beats the power of leverage. In fact, real estate itself is a commonly leveraged asset.
“Pay off your mortgage” is something that gets thrown around often, yet it is actually the last thing you want to do! Here’s why:
Scenario 1: You own a $200,000 property free and clear, and earn a net of $20,000 annually. This represents a 10% rate of return.
Scenario 2: You have the same property, however you put $40,000 down and financed the other $160,000. After the mortgage payment, you only earn a net of $10,000.
Seems like the first scenario is better, right? Well, not exactly. Your return on investment is actually much higher with a mortgage. That’s because you’ve invested less of your own money. In reality, you’re earning $10,000 a year on a $40,000 investment–that’s a 25% return.
From a rent perspective, think of it this way:
In scenario 1, you’re earning more monthly cash flow. However you’re always playing catch-up to your initial investment. Your first $200,000 is filling the gap, and it’ll take you 10 years to break even.
In scenario 2, some of your renter’s money will go to the mortgage, yes. However the money leftover is only filling a $40,000 gap. You’ll “break even” in 4 years, and begin realizing greater profits because you’re not playing catch-up.
3. Expanding your assets
Let’s expand upon the above scenario even further. Say you are really wanting to put your full $200,000 to work investing in real estate. You could put all your eggs in one basket, however the above example shows why you might not want to.
Or, you could use your $200,000 to put 20% down on 5 properties of the same value. At the same $10,000 profit per house, you can actually earn $50,000 a year. For the exact same initial investment as scenario 1, you’ve increased your profits by $30,000 a year.
Your rate of return is still 25% like scenario 2, however you’re now able to control five assets instead of one. Comparing these scenarios, you really start to understand the power of leverage.
A Warning About Over-Leveraging
Just as leverage can make a good investment even better, there are two sides to every coin. Leverage can also make a bad investment even worse. In the event you did want to leverage your assets to own five properties, you’d want to make sure you have enough liquid cash to pay for big costs. Roof repairs, water damage, flooring, and even un-ideal tenants can be costly.
Avoid leveraging to the point that you can no longer care for the assets you have, or afford the unexpected. Even with a well-maintained property, you can leverage to the point that it no longer cash flows (like counting on appreciation to make it better). When the winds change, like they did in 2008, you could find your investments unsustainable.
Similarly, under-capitalizing a business or leveraging against stocks to buy more stocks can magnify your losses. Sometimes you can even lose more than you started with.
However just because it requires your careful attention does not mean it shouldn’t be done! It simply means that you should build strategies and avoid speculation. Aim for certainty wherever possible.
Should You Leverage Your Assets?
Borrowing against and leveraging your assets should be done with care. However putting your dollars to work is not only for the wealthy. Leverage may be the key to increasing your cash flow now, rather than ten years down the line.
And as much as the wealthy use leverage to make their personal economies more efficient, they also maintain liquidity. This liquidity provides certainty, and allows them to make investments with confidence.
Want to discuss your own assets, and how to increase your cash flow? Speak with a Prosperity Economics Advisor today.