A common money mistake is to pay for assets in cash. Most often, people do this because they hope to avoid paying interest. Unfortunately, there’s no way to avoid interest—you either pay it, or you pass it up. And choosing to buy assets “free and clear” prevents people from achieving an even better wealth trajectory. Let’s explore what leverage is, and the true wealth-building power of using your assets as collateral to buy new assets.
The Myth of Paying Cash
For the average person, avoiding interest costs may be fine. However, more often than not, this “myth” puts people in a bind. Like we said, you either pay interest or you pass it up. When you pass it up, this is called opportunity cost. Consider, for example, buying a car. Say you’ve got your eye on a $30,000 car, and have just enough in your emergency/opportunity fund to do it. If you pay cash, not only can you avoid a monthly payment, you can also avoid a few thousand dollars worth of interest costs. Right?
What most people don’t factor into this calculation is the opportunity cost. In other words, the cost of paying in cash rather than doing something else with the dollars, like keeping it in a high-yield, interest-bearing account. Not only would you be losing the potential compounding interest this $30k could earn, but you also lose your emergency/opportunity fund. So you may not have a car payment, yet if something comes up that you have to pay for, you no longer have that cushion. At most, you use what would have been a car payment to replenish that account, yet you’ll never recoup what that $30k could have become.
If that doesn’t make you stop and think, consider this—the wealthiest people in the world don’t pay for their assets in cash. They use leverage. Yet arguably, they have plenty of money to pay for assets in cash without batting an eye. So why don’t they?
Because done properly and wisely, leverage can help them multiply their profits and have more control than cash in the bank.
Why is Leverage So Powerful?
The secret of leverage is that it helps increase the velocity of your money. Leverage allows a single dollar to do multiple jobs for you. Think of it this way: when you pay for something with your own cash, it’s doing one thing. That “thing” is making a purchase. When you use that money as collateral to purchase another asset, several things are happening at once. For starters, your account continues to earn interest uninterrupted. At the same time, you get a new asset (hopefully one with cash flow). And if that asset does have cash flow, that cash flow can be directed to paying the loan balance.
So instead of having your dollar be a 1-for-1 transaction, you have many things happening at once. Without spending any of your own money, you now have an account earning interest AND cash flow (which will eventually increase once the loan balance is paid down by that cash flow). You’ve increased your assets without creating an extra payment, reducing your emergency/opportunity fund, or increasing your opportunity cost.
Still unconvinced? Here are 3 reasons you may want to leverage your assets…
1. Financial Flexibility
When people spread their dollars too thin, they lack financial flexibility. This happens when people have separate accounts for every purpose their dollar can do (i.e. having dollars doing one job). They have a 401k for retirement, a 529 for education, a savings account for emergencies, credit cards, and all different kinds of insurance. Yet how effective can any single account be when you have to spread your money thinly between them?
Having one account that serves MANY purposes is actually much more flexible and efficient. With whole life insurance, for example, you can add disability insurance and long-term care, amongst other things, and ALSO leverage your cash value with a policy loan for anything you want. You want to use your cash value as collateral for a rental property? Done. You have kids going to school who want more flexible loans? Use a policy loan. Emergencies? Covered. Opportunities? Also covered. And you can have lots of income options later in life, thanks to life insurance.
A savings account you can leverage means you don’t have to spread your dollars too thin, and you also don’t have to deplete your account every time you need to do something. Instead, you can leverage it, and earn interest and dividends while you use it.
2. Better Cash Flow
Being able to leverage your assets not only makes new opportunities possible, but it also makes them even better. There’s no better example than the real estate example because people love to buy real estate and it’s accessible. Not only that, but it’s common for people to be afraid of long mortgages. Yet as we’ll show you, the long mortgage is actually GREAT!
Mortgage and Cash Flow
Let’s look at how leverage can impact your mortgage.
Example 1: You pay for a $200,000 property in cash. The cash flow on this property is a net of $20k annually. If you put this into a Truth Concepts Rate Calculator, you can see that works out to be a 10% annual return. Not bad, right?
Example 2: This time, instead of paying cash, you decide to take a mortgage on the property. You put $40k of your own money down on the house, and then you borrow the other $160k. Because you have to pay the mortgage with that cash flow before you get to enjoy it, you’re only making $10k. If you stopped the comparison there, you might be tempted to think that’s a worse deal. After all, you’re paying interest AND making less money. Yet that’s not really true, is it?
In reality, you only invested $40k into the property. With $10k of cash flow, you’re actually getting a 25% return on your investment. And you’ve still got $160k in an account somewhere, earning interest and ready in case of other emergencies/opportunities.
When you do it right, leverage can actually make a huge difference in your wealth-building journey. And if you still think higher cash flow is better, think about how long it will take you to recoup your initial investment. In the first example, it would take you 10 years to break even on your investment. You might be enjoying an extra $20k of cash flow, but you’re doing so at a large expense that will take time to recover from. In the meantime, that’s money you don’t have for emergencies/opportunities. On the other hand, it will only take 4 years to break even on your investment in Example 2. Everything after that is pure profit. And once the mortgage is paid, you’ll get a nice bump in cash flow again, or you can sell the property for a nice lump sum.
3. Asset Expansion
Let’s keep with the mortgage example for a bit longer. Let’s just say you really want to invest $200k. Doing so won’t hurt your bottom line, and you really don’t want to have loans. You could invest all of that money into one property, sure. Or, you could use what you’ve learned from Example 2 to invest in 5 properties with a down payment of $40k each.
Now, instead of one property with $20k of cash flow, you have 5 properties for a total of $50k in cash flow. The rate of return is still only 25%, but now you have control of $1 million worth of assets with only a $200k investment. If you had stuck with Example 1, you’d have $200k doing the work of $200k, a 1-for-1 deal. Instead, you’ve created a VAST expansion of your Net Worth, cash flow, and overall portfolio. That’s an $800k difference in results from the exact same $200k investment.
If you did a 30-year mortgage, you’d own all 5 properties free and clear in 30 years. At a modest appreciation rate of 4%, your $1 million RE portfolio could be worth more than $3.2 million.
A Word of Caution on Leverage
Although we love the power of leverage, it’s important to note that it must be done with care. Not all investments or purchases are made better with leverage, and it can actually make a bad investment worse.
For example, owning five properties may be greater for your cash flow. However, if you invested ALL of your capital into these properties, you can find yourself in hot water if your properties need major repairs, or you have a case of destructive tenants. Even in the best of circumstances, you can find yourself needing to replace a roof here, and an HVAC system there. You’ve got to have additional capital if you’re going to invest big.
Even if you keep your properties well-maintained, there can still be issues of over-leveraging your real estate to the point that it no longer cash flows. For example, if you’re counting on appreciation to make your investment a good one, but the real estate market takes a nosedive, you could have an unsustainable or even worthless investment. The same can be said for investments in the stock market or your business. There’s always risk when you invest, so it’s important to have a good balance between leverage and liquid capital. And, always do your due diligence before signing anything.
While there’s certainly something to be said of taking caution, don’t take this as an omen! If you want to invest, leveraging assets can be a phenomenal tool. Just make sure to do your research and work with people you trust. (And keep speculation to a minimum!)
Want to build your cash reserves? We’d be happy to put you in touch with a Prosperity Economics Advisor!