This week, we are going to talk about a topic that tends to be a hot button topic–leverage. First of all, let’s define leverage. Broadly speaking, leverage in finance could define anything that has the ability to increase investment returns. It could be something like having great financial advisors or help to maximize your own earning capability. Specifically, for this discussion, let’s limit it’s definition to how it is traditionally used in finance. Leverage is debt.
Robert Kiyosaki very simply boiled down debt into 2 forms: good debt and bad debt. Bad debt is debt that is used to buy things that won’t make you any money. For example, using debt to buy a television will not make you money and, therefore, is bad debt. Good debt is used to create more money than the debt itself. An example of good debt might be a fixed rate mortgage on an investment property. In the last couple of lessons, I have talked about cap rates. As you may recall, cap rates also equal the net operating income of an asset without debt (leverage). So, if you bought a $100,000 property by paying the full $100,000 without a mortgage, and the cap rate of the property was 10, then your return on investment would be 10 percent. However, what if you bought that same house by putting down $20,000 and borrowing $80,000 from the bank at a very low interest rate? Well, the return on investment might actually go from 10 percent to 30 percent. What does that mean to you? It means doubling your money is just over 2 years instead of over 7.
The poor and middle class try to get out of debt. The rich try to create more debt in the form of leverage. Leverage is FUNDAMENTAL in creating wealth. Fear of debt will keep you from becoming wealthy.
Now…understanding how to use debt is a skill set that you must master or have advisors who can help guide you. While debt is the cornerstone of wealth building, it also cannot be taken lightly. Understanding how interest rates fluctuate and how different loan structures affect repayment etc are critical.