Pssst. Hey! You want to know a secret?
This secret has helped many people become financially free! It’s what the wealthy use to buy their investments and multiply their returns! Want to know what it is? It’s OPM (Other People's Money). Specifically, were talking about DEBT!
One of the most POWERFUL tools used by the wealthy is financial leverage or debt.
I should probably start off by addressing the elephant in the room and that is this: a lot of us have been taught that all debt is bad.
Dave Ramsey makes a pretty good living telling people that debt is bad–and maybe that could be really good advice for some people depending on their goals... If your goal is to become debt free and pay off your house and become a successful middle of the road American, being debt-free can be a rewarding accomplishment.
But! if you are looking to become financially free, you may want to consider another point of view before you go all in on the debt-free idea.
DEBT is a TOOL. And, like a knife... If you don’t use it properly, you can hurt yourself.
That is exactly why you don’t ever give a 2-year-old a knife, but to say that all debt is bad is like saying knives are inherently bad, or guns are bad. It’s not the tool that is the problem. The lack of discipline and knowledge about how to properly use debt as a financial tool is the problem. Tools are created to make things easier. Think about that the next time you’re about to cut your ham sandwich in half...
The fact is: the wealthy use debt much differently than the poor and the middle class.
One example of a poor use of debt is when people rack up a ton of credit card debt to finance a lifestyle they cannot afford. They see a credit card as free money and begin to purchase things without considering the cost or their ability to repay. The consequences of carrying a balance for a long time on a credit card and only making the minimum payment every month is a racket.
Those who don’t end up filing bankruptcy get stuck paying this debt for decades before they can ever get free from it. The amount of money they spend in interest is staggering. The consequences of being irresponsible with debt can be debilitating.
The wealthy use credit cards in a completely different way.
They use them to help track their spending and even get free cashback and other perks from the credit card company just for using them. Paying off the balance every month helps them avoid any finance charges and assists them in building up their credit profile. As you can see, those who use credit cards properly are rewarded while those who make poor decisions pay a penalty.
Another blunder of the poor and middle class is borrowing as much as they possibly can to purchase a vehicle. While owning a decent car is a necessity for most people, driving around in something you can barely afford can be damaging to your finances, no matter how much it puffs up your ego.
By allocating a large portion of their income to make a car payment, they are handicapping themselves financially and increasing their risk of defaulting. Because cars can depreciate faster than the loan is paid down, many people owe more than what their vehicle is worth. The racket here is when people decide to “upgrade” their vehicle every few years and roll that negative equity into the next car, they are increasing their liabilities at an increasing rate.
Unfortunately, there are tons of people literally driving around their net worth, which in many cases is negative. I completely agree with paying off these debts as soon as possible. Staying in this sort
of debt can really hamper your financial mobility.
Ultimately, leverage helps you do more with less, leverage magnifies financial outcomes. This is why it’s so important to be careful when using leverage. You really want to be sure that you are magnifying outcomes that benefit your financial statement instead of harming it.
Alriiight, enough with the bad uses of debt. What about examples of GOOD debt?
Well, the wealthy use debt to buy assets. Specifically, they focus on assets that appreciate and generate income.
The key to increasing your wealth and income is buying as many of these wealth building assets as possible. My favorite asset to buy provides enough cash flow from the asset to completely pay for the debt. Investment real estate does this. Real estate also appreciates over time. When you can combine appreciation and cash flow with leverage into a relatively low risk asset, you’ve hit the jackpot!! This is why real estate is such a huge part of our portfolio.
I want to give you a quick example of how powerful leverage can be.
Now, lets look at the UNleveraged equity growth of the same property. The only thing that changes here is the amount of cash we are using to control the same deal. Once again, our purchase price is 260K, but in this case we need the full $260K cash (which is 5X the amount of money).
If we turn that $260K into $740K, we have multiplied our investment 2.85 times and generated an average annual equity growth of 28%. 28% average is not bad. In fact, it’s great! In this case, the cash flow will be quite a bit higher when you are not using debt to leverage, but the additional cash flow is not going to move that 28% average anywhere close to the 102% that you’re getting by leveraging.
Now, for those who recognize the last 10 years has been quite irregular with asset values and want to look at longer time frames, or for those who still think investing in the stock market is where it’s at, let’s take a look at the values from the point the original home was built and sold. So, the County records shows the home was originally purchased for $46,500 at the end of May 1975. At that time, the S&P was valued at $519 ($519.07). Since that time, the value of the home has increased 15.9 times over the original purchase price averaging 34% per year. Over that same period, the S&P has gone up only 7.2 times which averages out at 15% per year.
And don’t forget, investment real estate provides cash flow and tax benefits not available to stock investors.
If you’d like to dig deeper into the stocks versus real estate debate, I suggest you take a look at a whitepaper written by the San Francisco branch of the Federal reserve. It’s called “The rate of return on everything, 1870–2015”.
In the 120 page investigative report, the federal reserve estates: we find that real estate, not stocks or equities has been the best long run investment over the course of modern history. (See page 12)
This report later states that “...the volatility for [real estate] is substantially lower [than equities]–or stocks”. Clearly, real estate is a better performing investment over the long period.
A few things you want to look out for when using debt:
1. Leverage ratio. You don’t want to over leverage. Too much leverage can make any investment risky
2. Pay attention to the term of the financing and the term of your investment. You want these time frames to match up. As a side note, if you are going to use bridge financing to stabilize an asset before getting permanent financing, make sure you consider the risk of potential interest rate creep of the permanent financing when underwriting the deal.
3. You’ll want to consider whether the lender requires a personal guarantee. If you can avoid this, you should.
4. Take a look at the volatility of the asset being financed. Assets with high standard deviations shouldn’t be leveraged (in my opinion) because the risk of default is too great. I’ve personally gotten burned doing margin plays on wall street and have learned this lesson the hard way.
5. If you are going to be using debt in combination with a retirement accounts for investing, there are some special tax implications to consider. Talk to your CPA regarding this.
6. Debt arbitrage effect on cashflow (interest rate paid vs. cashflow earned)
It generally doesn’t make sense to borrow at a rate of 5 and invest in something that is projected to yield 3% cash-on cash, unless you can handle the negative cash flow and there is some larger upside that makes the negative cash flow worth while. We personally don’t do this, but there are some out there that do.
7. Last thing is Positive Leverage. Take a look at the interest rate vs. the capitalization rate of the asset, making sure that the cap rate is higher than the interest. Once again, if there a large upside to the deal, it could be worth considering using negative leverage, but it adds quite a bit of risk.
A few advantages using debt:
1. Advanced investors used debt to Revive otherwise Dead Equity. If you look at your return on Equity and its not performing well, you can use debt to extract that equity for a few things.
a. For tax free income (debt)
b. To recover your cash (removing the risk to that capital)
c. To redeploy into other investments adding velocity
2. Interest rates and inflation–weird phenomenon (currently). If you are borrowing at a rate of 4% when inflation is running at 8% or, they are literally paying you to borrow money assuming you buy something that increases over time.
3. Speaking of inflation, debt is a great way to short the dollar (What does that mean?)
If you understand the time value of money, you know that todays dollars are worth more than tomorrow’s dollars. When you leverage into investments, you are borrowing money today to purchase something that goes up in value over time and you are paying back that loan with tomorrow's dollars.
Because of this, inflation is actually one of the mechanisms that helps investors automatically increase their wealth
4. Using fixed rate debt to purchase cash flowing assets that adjust with inflation like investment real estate means that your cash flow will automatically go up over time.
The longer you own the asset, the more your cash flow grows.
In summary, the wealthy use debt much differently than the poor and middle class. Wealthy use debt as financial leverage to increase their assets while the poor and middle class only use debt to increase their liabilities.
Owning appreciating and cash generating assets like real estate over long periods of time is a sure-fire way to become wealthy and when you use financial leverage, you will increase your yield exponentially. And,90% of all millionaires have been created by investing in real estate.
In the Passive Wealth Investors Club, our members have access to thoroughly reviewed commercial real estate investments that use financial leverage to help magnify returns. What’s great is our members get access to this leverage without ever having to worry about signing a loan because it’s built right into the deal.
If this sounds like something you’d like to learn more about, make sure to sign up to our email list and become a member.