The Power of Leverage

Carrying personal debt can be a scary and intimidating financial tool to many people mainly because most of the world does not understand how to use debt to their advantage. There are actually two types of debt: good debt and bad debt. Most people are scared of debt because they only know about bad debt and do not understand what good debt means.

Bad debt comes in the form of credit cards, lines of credit, loans on automobiles, and other ‘things’ that over the long term become a liability on our financial score card. I consider a personal residence mortgage a bad debt because it takes money out of your pocket each and every month

Good debt comes in the form of credit cards, lines of credit and loans that are used to purchase investments that over time put money in your pocket and increase in value. This additional revenue in turn becomes an asset on your financial score card. I consider a mortgage on a rental property that produces monthly cash flow a good debt.

The difference between good and bad debt can be summed up quite easily. Bad debt takes money out of your pocket and good debt puts more money back in your pocket. The majority of people today do not understand this fundamental difference and think all debt is bad debt. Using good debt can be a powerful tool which we refer to as leverage.

One of the most powerful tools successful people use on a regular basis is leverage.  Leverage means utilizing the strengths of other things, processes, and people to do a lot more than you could do alone.  Leverage helps you get the most out of your resources, because you free up your time to work on the activities that are most valuable to you.

Be aware that using leverage as a financial tool is a double edged sword as it can significantly increase your profits but the other side to that is it can also  significantly increase your looses if not used effectively.

Leverage can be used in a number of ways, but the two most powerful are leveraging your time and leveraging your money. Ultimately, leverage, if used wisely, will allow you to spend your time, energy, and money doing the things that you enjoy and are passionate about.  The definition of leverage is “using given resources in such a way that the potential positive or negative outcome is magnified.”

Archimedes once said "Give me a lever long enough and I could move the world."

In real estate investing, we use leverage in a number of ways. To illustrate this point clearly, I am going to use the following example using very round simple numbers and not take into account tenants, taxes, and many of the other wonders that come along with real estate.

Let’s say we find a property and purchase it for $100,000 and we buy it with all cash!

Then we sell this house in 5 years for $200,000 which results in $100,000 profit.

This gives us a total of 100% return on investment.

Now, traditionally we don’t buy a house with 100% cash, do we?

Typically we go to the bank, get a mortgage and we buy it with 10-25% down. This means for every dollar we put up, the bank gives us four. Our leverage in this case is that the bank lends us 25%, which equals a ratio of 1:4. Let’s use this same example only we’ll put 10% down.

In this case we are going to the bank and getting a mortgage for the remaining purchase price which would be $90,000 in this case, since we are putting up $10,000 (the 10% down payment).

Using the same example as the previous sale, the property sells for $200,000 in 5 years. We still make the same $100,000, but we only utilized $10,000 to do it this time.

This makes the return on investment over 1000% and that is the power of leverage.

So here’s the deal breaker: if you knew and understood how to utilize the power of leverage and had the $100,000 to invest today – wouldn’t it make more sense to buy 10 houses using 10% down rather than one house for 100% cash? And get a return on your investment of 1000% versus 100%?

That’s truly the power of leverage. Let me ask you a question:  are you struggling on a monthly basis to ensure you pay down or pay off your mortgage faster? If this is exactly what you’re doing, in my opinion you are creating dead equity in your home that you could be leveraging to purchase investment properties.

With historically low interest rates in place today you could be amassing a fortune for tomorrow by using the power of leverage.