How to Use Leverage to Build Wealth
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Summary:
Leverage is a phenomenal tool that allows you to take on debt or borrow against the assets you already have to increase your returns on a given investment. Here’s how to use leverage to build wealth. Whether it be real estate investments, equities, or even leveraging your own time in the modern world, leverage is quintessential to both preserving existing wealth and growing wealth at a much quicker rate. In order to fully maximize leverages’ benefits, you must understand how exactly it is used, and both the upsides and downsides of using it.
Leverage is paramount for those looking to achieve full financial freedom and build wealth. To put it simply, in a financial sense, leverage is the process of using debt or financial capital acquired by third parties to increase the returns of an investment. Debt and leverage in the modern sense have their roots in the 17th century Dutch East India Company. Here, the first LLCs were established to both sell debt and leverage against existing assets.
However, nowadays, the process of using leverage is much more sophisticated and commonplace. For instance, if you own your own home, you are using leverage. If you invest in a fund that features short selling, you are using leverage. The process of taking on debt can be scary to some but done in an intelligent matter, it can be one of the best ways to manage your assets and build your wealth.
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Leverage in real estate investing
If you own your own home, then you already have used leverage. Unless you are the type of person who has so much money that you paid 100% cash for your property and don’t care about leveraged returns, you probably have a mortgage. This means that you borrowed money from the bank or a third party financial firm to buy the property or refinance the property. There are a few ways to use leverage in the real estate market when investing.
Using leverage to multiply the returns on asset appreciation
The most common way for people to use leverage in real estate investing is to obtain a mortgage for a home, wait until the price increases and then sell the home. Most people who have stable jobs can obtain a mortgage. A mortgage allows you to put a smaller deposit down, which in most cases is a small fraction of the total property’s price. For instance, if you have a $100,000 property and you pay a 10% deposit and obtain a 90% mortgage, you have put $10,000 of your own money with an initial investment into buying the property, and $90,000 you have borrowed.
You then make mortgage payments on the debt the bank or institution has given you. You can further leverage this investment by borrowing money and using your property as security to buy another revenue-earning property. As you generate equity in the new property you can do it again and again buying more properties and building more cash flow.
Pro Tip
The advantage here is that you have put down a deposit that only is a fraction of the total price of the asset. However, the growth the asset is doing is based on the entire price of the asset.
An example of leverage in real estate
Often it’s easier to see the power of leveraging by using examples. We will use this table to break it down.
In this example, we have Scott, Bob, and Tom. All three of these individuals bought a house on the same street for $100,000 at the exact same time.
| $100K Purchase Price | Scott | Bob | Tom |
|---|---|---|---|
| Mortgage Amount | $0.00 | 50% | 75% |
| Debt | n/a | $0.00 | $0.00 |
| Initial Equity | $100,000 | $50,000 | $25,000 |
The only difference is that Scott paid 100% cash for the purchase price of the asset, Bob took out a 50% mortgage, and Tom took out a 75% mortgage. To keep things as simple as possible, we will assume that both Bob and Tom have a fixed interest-only mortgage at 4% with a 30-year term.
| $150K Property Price at Sale | Scott | Bob | Tom |
|---|---|---|---|
| Interest Payments Accrued | $0.00 | $10,000.00 | $15,000.00 |
| Mortgage Balance | n/a | $50,000.00 | $75,000.00 |
| Total Equity | $150,000.00 | $90,000.00 | $60,000.00 |
| Total Profit on Initial Equity | $50,000.00 | $40,000.00 | $35,000.00 |
| Total Return on Initial Equity | 50% | 80% | 140% |
Now the property is sold five years later for a higher price, $150,000 to be exact. You can probably do the math in your head; for Scott, it’s easy. If he invested $100,000 dollars cash and sold the property for $150,000, he made a 50% ROI. However, as you can see, the ROI is much higher for those that used debt, including when applying the interest on the mortgage payment and considering a smaller down payment.
Regardless of the interest on the mortgage payment, those that contributed a smaller down payment and used leverage from the bank greatly increased their ROI. For those looking to create wealth using financial leverage and borrowed money, this is a very straightforward way to do so. But the use of leverage doesn’t have to stop here.
For example, imagine Tom decides to leverage the property further by getting a $25K home equity loan on the first home and using the money to put a 25% down payment on another $100K property. After 5 years, he sells the second property for another $150K.
| 2nd $100K property | Tom |
|---|---|
| Uses home equity loan to pay for the down payment | $25,000 |
| Debt | $100,000 |
| Initial Equity | $0 |
| Interest Payments Accrued | $20,000 |
| Total Return on initial investment if Tom sells for $150K | 260% |
In this scenario, Tom would generate a 260% return on his initial $25,000 investment.
Leverage means additional risk
Whether it’s an investment property, a rental property, or your own home, it’s easy to see the income-generating potential of leverage. However, leverage does have its downsides. The more leverage you use, the greater your risk of losing more of that initial equity you have invested. Now let’s look at what happens if that $100,000 property declines 10% in five years and all three buyers need to sell.
| $90K Proper Price at Sale | Scott | Bob | Tom |
|---|---|---|---|
| Interest Payments Accrued | $0.00 | $10,000 | $15,000 |
| Mortgage Balance | n/a | $50,000 | $75,000 |
| Total Equity | $90,000 | $30,000 | $0.00 |
| Total Return on Initial Equity | -10% | -40% | -100% |
You can see the downsides of leveraging here as well. If the market declines, and thus the property value declines with it, you can lose a much higher percentage of the initial capital you put in the real estate investment. In the previous example, Tom would have a 200% loss on his initial $25,000 investment. Evidently, it’s important not to become overleveraged when investing in real estate. One of the main reasons why the financial crisis took hold is that people were using 100%+ leverage. Something more along the lines of a 20% deposit down and a 80% mortgage payment is considered safer and more standard.
Pro Tip
Using leverage can also have huge tax advantages and tax benefits. Remember, if you have an asset that you own 100% and you take out debt on the asset, it’s much more advantageous than selling it for tax purposes.
For instance, if your $100,000 property is now worth $150,000, you can take out the extra $50,000 you made in property appreciation in debt by refinancing the asset. If done properly, you can grow your wealth, tax free.
How to leverage home equity
Are you a homeowner who is interested in diversifying your portfolio by investing your home equity? You don’t have to sell your home to leverage your home equity.
There are multiple options if you want to tap your home’s equity and use it to invest. These include shared equity programs, mortgage refinance, and home equity lines of credit (HELOCs).
Sell a share of your equity
Home equity investments are probably the least known (and most flexible) method to tap into your home equity for investing. They are a unique way to leverage your home because you don’t have to get into debt or make monthly payments. Instead, you sell a slice of the future equity in your home (while maintaining 100% ownership of your home). When your home is sold — or when the contract term ends — the investors receive their share from the sale. If the value of the house increases, so does the amount the investor receives. If the house drops in value, the investor also shares in the loss.
Using leverage in rental returns for cash flow
When buying an investment property, in particular, most people are attracted to rental returns that are monthly “cash-flow” positive. Cash-flow positive means that after all your expenses, such as mortgage interest payments, HOA fees, and management fees, you are still taking home a profit at the end of every month or year.
Some people are afraid of taking out too much debt on an investment property because the higher the mortgage payment, the less cash flow you will have. However, just as asset appreciation gives you a better return on equity if you use debt and leverage, so does cash flow.
Using leverage in the financial markets
Leverage is by no means limited to real estate. Leverage is also used by the world’s first and foremost hedge fund managers and private equity titans in the financial markets. Some retail equities traders use leverage as well. However, be forewarned; trying to trade equities using leverage can be incredibly risky if you don’t know what you are doing.
Private equity funds
Private equity is a form of private financing in which investors invest directly in companies or facilitate buyouts of these companies. They do this by using borrowed money, or borrowed capital. Typically, private equity funds will use a small portion of their own assets and borrow the rest of the money from a bank or financial institution. This is where the term “leveraged buyout” comes from. By investing in a private equity fund, you can place capital with those who know exactly what they are doing with leverage to hopefully reap large profits and gains.
Short selling funds
Buying on margin and short selling is another relatively risky venture. This is where you borrow shares from a financial institution, wait for the prices of the shares to go down, sell the shares, and then take the margin between both. The movie The Big Short showcased how some investment managers made an absolute killing while shorting selling equities and derivatives related to the stock market. Investing in funds that have proven short-selling experts could be a fast track to wealth creation.
Leveraged ETF funds
ETF funds are funds that track the stock market, such as the S&P 500 or the Nasdaq 100 index. These leveraged exchange-traded funds (ETFs) use financial derivatives and debt to amplify the returns of the underlying index. Traditional ETFs just track the securities in an index with a 1:1 ratio. However, leveraged ETFs can have a ratio of 2:1 or even 3:1 ratio.
Leveraged ETFs are a double-edged sword because although they can generate significant gains, they can multiply your losses. If you are bullish about the medium to long-term prospects of the market, then this could be an option.
The risk of leveraged investments
As we mentioned above, leverage is a great income multiplier, but it can also amplify losses when things go South. So, it should be used with caution. The hedge fund Long-Term Capital Management (LTCM) is a classic cautionary tale of the risks of excessive leverage.
LTCM was a highly-leveraged fund that was founded in 1994. The fund was run by a team of Ph.D.-certified arbitrageurs. Two of them, Robert Merton and Myron Scholes, had won the Noble Prize. In the initial years, the fund generated annualized returns of up to 41%. However, those returns relied on aggressive leveraging. At one point LTCM had an effective leverage ratio of more than 250 to 1. However, in 1998 the fund lost $4.6 billion in four months because of its high leverage and exposure to the 1997 Asian financial crisis and the 1998 Russian financial crisis. The Federal Reserve had to step in to bail out the company and avoid a wider collapse of the financial markets.
FAQs
How can leverage be used to grow wealth?
You can use leverage through borrowed money to increase your returns on a given investment. Since you make money on the performance of the entire investment amount, you can use other people’s money and contribute a small amount yourself.
How do you leverage your income?
You can leverage your income, even if you make little money, in many different ways. However, the main purpose of leveraging your income is to use your current income to create passive income. This can be done by obtaining income from dividends in the stock market to passive income derived via cash flow from rental properties.
What is leverage investing?
Leverage investing is using other people’s money to increase the return on your investment.
Is leveraging a good idea?
Leverage is only a good idea if you know what you doing, are safe about it, and don’t use too much.
Do millionaires pay off debt or invest?
There isn’t a one-size-fits-all answer to this, but financially savvy millionaires typically stay away from debt for personal purchases. However, most ultra-wealthy individuals will leverage their assets by borrowing against them (or using other investors’ money) and reinvesting the funds into assets that make a higher return than the cost of the debt. Understanding how to use leverage in their business investments allows them to build more wealth than they could achieve using their own resources.
Key takeaways
- Leverage is a tool that can be used to build wealth.
- Leverage has been around for hundreds of years, but recently it has been easier and more accessible to everyone.
- Real estate is one of the most common ways for people to achieve investment returns by leveraging.
- You can use leverage in real estate to increase your return substantially by using a mortgage to take advantage of asset appreciation.
- You can also use leverage related to your cash flow from real estate to maximize greater returns.
- In the financial markets, leverage is also widely available. However, it’s much safer to leave this kind of leverage to experts managing your portfolio.
- Leverage can also be very tax advantageous by using debt from assets instead of capital gains.
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