Leverage can make all the difference. Work Hard or Work Smart.

This past weekend I was out with a group of about 25 people to do some service clearing out dead trees and brush to convert some forest area into a campsite to be used by youth for years to come.

We mostly used simple tools, chainsaws and loppers or pruning shears. Luckily there were some big machinery there as well but for the most part it was all brute force manual labor. I used the loppers most of the time to cut out the smaller branches and brush with roots or stems several inches thick.

Later in the morning I was helping to pick up and move the cut branches and logs and one of the few women that were there was using the loppers to cut some of the foliage.

She is a middle-aged woman and pretty nor very muscular. She was attempting to cut a root that was a couple inches thick. I pulled on it so she could cut deeper and she said, “I hope I can do it.” I responded with, “I know you can do it. That’s the power of leverage.” And sure enough, after a little grunt she was able to slice through that root without too much effort.

That made me think of an important lesson using leverage when it comes to investing. Banks do it. They borrow your money (your deposits) and pay you a low interest rate to keep it there, then they loan it out to other people and businesses at a higher interest rate. They are in essence using other people’s money to make money. They are leveraging your deposits.

That woman, or even I, would not be able to cut through that root with scissors or some small hand tool. The loppers have extra long handles allowing to apply more leverage to provide extra force.

There are not many investments that you can use leverage to increase your returns. The only ones that come to mind are Business and Real Estate. They both work in a similar fashion.

Leverage is only one component to building wealth. The others are compound interest and velocity. Individually they will help you advance financially. But only when combined together do you really make things happen.

A brief overview

We have discussed compound interest before so we won’t dive deep here. It is when your money earns interest or some other type of return which then is included in the sum for the next round of interest so the interest earns interest.

Velocity is basically scaling bigger. Using the returns you get to purchase more and continually increase your earnings at an exponential pace. For example start with one rental, then in a year or so buy another, which hopefully doubles your cash flow, then maybe less than a year buy another or two, try to continuously double the # of rentals which in turn multiplies your cash flows at an ever increasing pace.

Those two components can be done fairly easily on their own. The velocity may be a bit more difficult if you don’t have a lot of cash available to start with. That’s where leverage comes in.

Leverage gives you power. Leverage allows you to earn a return on your money AND someone else’s money. You cannot really leverage stocks or bonds other than I suppose borrowing money from somebody and buying using their money. But that would be very risky and I highly advise against it. But even then you can only buy what you have money to buy. $1,000 can only buy $1,000 worth of stock, actually a little less since you have to pay a trading fee.

But with Real Estate and Business, you can borrow the funds with very little of your own money. You can buy a $400,000 property or business with anywhere from 10-25% down. This allows your money to grow at a faster pace. More so than if you just paid it all in cash. Let’s walk through an example together:

Power of Leverage

To keep things simple we’ll use round easy numbers.

You borrow $100,000 either to start a business with equipment and such or to buy a cash flowing rental property. In either case you earn the same return (for simplicity) we’ll say 10%. The amount you borrowed of course needs to be paid back and they don’t give it to you for free. For this easy example we’ll say you borrow at 5% interest from the bank. Remember from earlier, the bank pays its depositors and lends out that money. So the bank is also making a nice return.

So your 10% return earns you $10,000 minus your 5% interest of $5,000. Giving you a net earning of $5,000. We are assuming all other costs are already accounted for in the 10% return. But also consider that you probably did not get 100% financing so you put a down payment of your own money of $10,000. Making the full purchase price at $110,000. So your $10,000 is also earning 10%. So removing the bank costs you actually earned $6,000 ($10k * 10% plus $100k * 5%).

Alternatively you could have just put your $10k into a savings account or CD earning at the most about 2.3% in today’s rates which would give you a whopping $230 return. See now how leverage can help you grow?

Now, let’s take that $6k earnings and borrow more to either expand your business or buy more rentals. This is where the Velocity comes in.

You now use the $6k plus maybe another $4k of your personal savings to get you another $10k to put down and borrow another $100k. You do the same thing again and earn the same return.

So now your second year you are earning 10% on your $20k cash plus 5% on the $200k borrowed. Keep in mind you are also building equity as those loans get paid down. There are other points to consider as well such as depreciation and tax incentives, but we won’t go that deep in this discussion. Check out one of my recommended tax books if you want to know more about that.

So the second year you are able to earn $12,000 ($20k * 10% plus $200k * 5%). You just doubled your returns all from starting with one single investment of $10,000! And the beauty is that you can keep doing it. You now have $12k you can invest and repeat the same process and building more and multiplying your returns. This combines all three power sources, compounding, leverage, and velocity.

In this example we kept it simple using easy round numbers. But in real life if you are savvy enough to find the right deals and use the right leverage you may be able to get even greater returns than that.

This is basically exactly how I started scaling my investing. I started with one 4 plex that I could barely afford with a 10% down loan. Even then, borrowing most of the down payment from my 401k, essentially leveraging even more. That property cash flows about $1,000/month. I let that cash flow build and about 18 months later used it to buy two more properties using 15% down. Each of those currently cash flow about $750/mo. That will increase with time. So my initial investment, which literally was $6k out of pocket, and $20k from my 401k account, has used these three levers to now produce around $2,500/mo in TAX FREE income.

Again, had you just put your initial $10k into a savings account or worse, a CD, after 2 years at the highest current rates you would only have earned approximately $465 TOTAL. Which is better?

I understand how fear can hold you back. It almost stopped me. I’m so glad I didn’t let it. Read my previous post about getting over FEAR. If you want to get started in Real Estate Investing but don’t know how or where to look, contact me. Send me an email to CTRfinanceblog@gmail.com and we can talk. Partnering on an income producing asset is another form of leverage and velocity. You can only do so much with your own money. At some point you run out. But partnering can help grow more and better and reduce the risk as well.

I want to quickly cover another simple example of leverage. Let’s say you have $100k cash to invest. You can buy one single family home for $100k that will rent for $1,000/mo. Your return on investment is 12% ($12k annual cash flow/$100k; keeping it simple, not accounting for depreciation or tax savings). Let’s also say there is a 5%/year appreciation. So after 1 year your total net worth (only considering this property) is $117k ($100*5%plus $12k cash flow). There is no mortgage so your equity does not increase other than the appreciation.

If instead you took $100k and put 20% down on five $100k properties that each rents for $1k/mo, you are now using leverage and debt in your favor. The mortgage, insurance, taxes, etc on each are $500. So cash flow $500/mo on each. After one year, keeping things the same your total net worth is now $137k (($500/mo*12=$6k*5=$30k cash flows) plus ($500k*5% – $393k loans ($80k each minus debt paydown=$78.5k each after 1 year))).

You are getting appreciation on all properties, debt paydown on all properties, cash flow from each property. As the equity builds in each one you are multiplying your returns and cash flows. Your return on investment is now 30% ($30k cash flows/$100k investment). Almost triple the returns by just buying one property with $100k cash.

Return on Equity is ALWAYS 0. If you have equity available, USE IT! But don’t go out and get a HELOC to buy a car or boat or some depreciating liability. Use it to buy income producing assets.

Leverage is your friend if you do it right. Just like the woman who used leverage to cut a two inch thick root. You can accomplish more with leverage. It can literally change your life! Don’t just live below your means. EXPAND your means!