How To Use Leverage To Build Wealth
I majored in physics in college. When I think of leverage in the context of the physical world, I think of turning a small force into a bigger force, typically using a “lever”.
With the right lever, you can lift something 10 times your own weight, like this:
In the world of money, we also have access to a lever. This lever allows us to buy an asset worth 10 times more than the amount of money we have to invest.
This lever is called a loan.
The Basic Idea Of Money Leverage
Many non-investors around the world leverage their money to buy a home. You can buy a $200,000 home for $20,000 (or less). That’s leverage with money: using a small amount of your own money to purchase something much more expensive.
In this scenario, the cost of getting a $200,000 home for $20,000 comes in the form of loan interest. That means that over the course of many years you’ll make payments that total far more than $200,000.
You may take the next 30 years to pay back $300,000 for your $200,000 house.
It’s common personal finance advice to avoid taking on debt. This is often good advice because why buy a house for $300,000 paid over 30 years (using leverage) when you could buy it for $200,000 today (without leverage).
Good investors know that not all debt is bad. In fact, some debt helps make you rich faster.
Using Leverage To Build Wealth
I want to simply demonstrate how leverage is used in building wealth with a series of simple examples.
Let’s demonstrate this with a form of investing that you should be familiar with: the stock market.
Example without leverage
First, let’s remind ourselves what investing in the stock market looks like done the normal way.
Related: Return potential for mutual funds.
Let’s assume we have $10,000 to invest.
And let’s also assume that we get a 10% return on investment every year in the stock market.
|Years||Portfolio Value (10%)||Debt Amount||Net Worth|
Nothing surprising here, our $10,000 grows by 10% each year and therefore our net worth also grows by 10% each year.
Example with leverage (no interest)
Let’s see the power of leverage with the simplest possible example. You still have $10,000 but you are able to get a no interest loan of $10,000 to also invest.
Let’s see what happens to your net worth in this scenario.
|Years||Portfolio Value (10%)||Debt Amount (0%)||Net Worth|
This time, in 10 years we grew our net worth to $41,875. We were able to take advantage of the 10% returns on an extra $10,000, which significantly improved the growth of our net worth.
Example with leverage (with interest)
The reality is that nobody will give you a $10,000 loan with no interest. If you want to leverage your money, you’ll have to pay for it.
We still have $10,000 to invest, but this time our $10,000 loan comes with 5% interest. Let’s see what happens.
|Years||Portfolio Value (10%)||Debt Amount (5%)||Net Worth|
So in a more realistic scenario, our net worth grew to $35,586 after 10 years (compared to $25,937 without leverage).
It boils down to this:
We paid 5% interest on the loan while getting 10% return on the invested loan money.
If we invest the borrowed money, and if our return on investment is greater than the interest rate on that loan, then our net worth will grow faster. It’s that simple.
Great investors use loans to their advantage, because loan interest rates are typically below 10% (and sometimes below 5%). They know that the value of their investments will grow faster than the debt, so they will build wealth even faster.
Why I Don’t Leverage Money In The Stock Market
Our three examples used the stock market as our investment. It is possible to leverage your money in the stock market, but there are two reasons I don’t bother doing that.
- Stocks don’t cover loan payments
- I can make more money in other investments
The biggest reason is that leveraging your money comes with some type of regular payments. For real estate it is in the form of a mortgage, which includes loan principle and interest as well as insurance and taxes. For stocks it may just be interest only payments.
Truth is, I’m not an expert when it comes to investing in stocks. I know that some stocks pay out dividends, but that amount doesn’t seem to be sufficient to cover the loan payments. You may end up eating into your own bank account each month in order to make the payments.
The other reason I avoid stocks is that I know I can make better returns with other types of investments.
Lenders avoid stock market investors
If you go to a lender, such as a local bank, and tell them you’re interested in buying real estate as an investment, they’ll almost certainly be willing to talk to you about how to qualify for a loan.
If you go to a lender and tell them you want a loan to invest in the stock market, they’ll tell you to look elsewhere.
I think it’s because of the cash flow problem I described earlier. Lenders only want to give money to people who can make the loan payments.
Real estate investors can pay the debt with rental income from the property. Business investors can pay the debt with the income from the business. But stock investors can’t pay the debt with their stocks, because stocks don’t generate significant income.
Even if you DO want to leverage your money to invest in the stock market, you’ll likely only be able to do it directly through the broker that has your trading account. They have special types of accounts and rules around how much you can borrow.
How To Leverage For Maximum Net Worth With Real Estate Investing
I’ve meandered long enough. Let’s actually talk about how to leverage your money.
Related: 27% return potential for real estate investments.
As of the time of this writing, Kate and I have now bought three investment properties and our net worth has been climbing faster than we realized was possible.
I consider 10% ROI to be the bar for investing.
Over long periods of time, money in the stock market approaches 10% return on investment. You may do a little better or a little worse, but that’s been about the historical average.
With that in mind, here’s the power of real estate investing:
Leverage plus appreciation
The biggest driver of wealth in real estate investing is the combined effects of leverage and property appreciation.
Property appreciates in value about 3-4% per year on average. That’s about the same as the average rate of inflation in the U.S.
But when you add leverage into the mix, something amazing happens.
|Down Payment||Appreciation Rate||ROI from Appreciation|
The phenomenon is that the lower your down payment for the property, the greater your return on investment is from property appreciation. Let’s see how this works using a few examples.
For simplicity, let’s imagine a $100,000 investment property and see how different down payments result in different returns on your investment.
|Initial Investment (DP)||Property Value (after 1 year)||ROI after 1 year|
We calculate ROI by dividing the increase in property value by our initial investment.
So for the $20,000 down scenario, the calculation looks like this:
- $104,000 – $100,000 = $4,000 increase in property value
- $4,000 / $20,000 = 0.2 = 20% return on investment
The only thing that changes from one calculation to the next is the down payment. No matter what, you own that entire property and so you get full credit for it’s appreciation.
Regardless of your down payment, you’ll be $4,000 richer after 1 year. That’s why real estate investors want the lowest possible down payment.
Why pay $25,000 to get $4,000 richer when you could pay $20,000 to get $4,000 richer?
And why pay $20,000 to get $4,000 richer if you can pay $10,000 to get $4,000 richer?
See how powerful that is?
And it’s not a 1 year thing, your 20% ROI (or more) is compounding and will be realized each and every year!
Importance of positive cash flow in real estate investing
The leverage plus property appreciation mechanism is by far the most powerful one in real estate investing, but it takes more than that power to actually become wealthy.
Related: Why I call myself a cash flow investor.
There’s a reason why Robert Kiyosaki, author of Rich Dad Poor Dad, says that your home is not an asset.
Owning real estate comes with lots of expenses.
- Mortgage/Loan payments
- Possibly other things like HOA fees and utilities
Sure you can realize all the benefits of leverage plus property appreciation simply by purchasing a home and keeping it in good condition. But the costs associated with owning that property will be earning you negative ROI.
The way that real estate investors offset the negative return on investment from the expenses of owning real estate is typically to rent the space to individuals or businesses.
You get some form of rent and use that rent to pay the expenses of owning the home.
If you can break even, then your net worth will be growing at a rate much faster than what you can get in the stock market (assuming your down payment was 25% or less).
And if your rent payments are greater than your expenses, then you get an even greater return on your investment.
How To Leverage For Maximum Cash Flow With Business Investing
Increasing your net worth is a worthy endeavor, but there’s something that I’ve come to value even more as an investor: cash flow.
It’s true that significant amounts of cash flow can be generated by investing in real estate. And it’s also true that Kate and I have managed to replace a $60,000 per year job with our real estate investments.
But there is an even faster way to create cash flow with your investing, and that is through purchasing a business.
Measure cash flow ROI with “cash on cash return”
Before we go any farther, I want to describe my method for measuring cash flow return on investment.
We normally measure net worth ROI based on a compounding interest number. What ROI can I get for the next 10 or 20 years?
But with cash flow I measure how much cash flow I can create in the 12 months following the purchase of my investment.
This is done with a calculation called cash on cash return.
You take the total cash earned from the investment during the 12 months following its purchase, and you divide that number by your initial investment.
Cash on cash return in real estate
In my experience with real estate investing, I’ve seen cash on cash returns of between 10% and 50%. Typically you can expect something in the 10-20% range (if you invest well).
Here’s an example of what cash on cash return would look like for a real estate investment.
- Total rent earned = 12 months x $1,500 = $18,000
- Total expenses = 12 months x $1,250 = $15,000
- Total cash earned = $18,000 – $15,000 = $3,000
- Initial investment = $15,000 down payment + $3,000 renovation = $18,000
- Cash on cash return = $3,000 / $18,000 = 0.1666 = 16.7%
16.7% cash on cash return for a real estate investment is very realistic. Kate and I have done better than this, but we’ve also done worse.
We’re about to see that the cash on cash return for a business investment blows this number out of the water.
Un-leveraged cash on cash return for business investment
First, let’s consider how businesses are valued. The most common way to put a value on a business is to look at it’s average yearly (or monthly) income.
Let’s say that over the past 12 months Super Business 123 made $350,000 in revenue and spent $230,000 on expenses.
That means that their yearly income was $120,000 ($350,000 – $230,000) and their average monthly income was $10,000 ($120,000 / 12 months).
When you value a business you typically use a multiple of one of those numbers.
A common price for a business, particularly one that does less than $1 million in yearly revenue, would be 2-4 times the yearly income.
So we might value Super Business 123 (who had $120,000 income last year) anywhere from $240,000 to $480,000.
Imagine you had access to a lot of cash and bought the business for $360,000 without any leverage(loan).
You would probably expect to make at least $120,000 over the next year.
This would make your cash on cash return 33% ($120,000 / $360,000).
Already much better than the expected return of a fully leveraged real estate investment.
Un-leveraged cash on cash return for business investment
From our research so far, we know that using a loan to invest can significantly increase our return on investment.
The Small Business Administration (SBA) offers loans specifically for the purchase businesses. In fact, I’m working with a SBA preferred lender to purchase an online business this year.
SBA backed loans can be secured for 10% down plus a 2-3% fee. So basically 12-13% down.
If we used an SBA loan to buy Super Business 123, we would only have to put about $45,000 down on the $360,000 purchase price.
SBA loan terms are typically 10 years at 5-7% interest. This would give you a monthly loan payment of around $3,600.
After 12 months we would have made $120,000 from the business and paid $43,000 in loan payments, making our net profit $77,000.
Since we only put $45,000 down, our cash on cash return is 179%!!!
That’s more than TEN TIMES the cash on cash return of a respectable real estate investment.
Cash on cash is not net worth
I’m not trying to say that buying a business gives you ten times the return on investment of a real estate deal.
Business almost certainly has the higher return potential, but there’s a reason why real estate is the investment of choice for so many of the world’s wealthy.
Real estate offers huge tax benefits and passive net worth growth that businesses simply can’t compete with.
As far as I’m concerned you invest in real estate when you want to prioritize your long term net worth or reduce your tax burden, and you invest in business when you want to increase your cash flow.
Related: Cash flow or net worth, which should you prioritize?
As we’ve seen, using leverage can significantly increase your return on investment for just about any investment style.
Leverage is most common with real estate and business investments, but it can be used to your advantage in the stock market as well.
I chose not to discuss the risks associated with using debt in your investing approach, but the rewards are undeniable for savvy investors. Using debt to leverage your money can increase your ROI tenfold.