Leverage: The Key to Amassing Massive Wealth

by FI Fighter on July 7, 2013

in Real Estate Thoughts

Leverage

A lot of people are scared of debt, and for good reason. Seems like everyone these days is graduating with over $50k in college debt. Moreover, a lot of these younger folks also feel the need to purchase a new car, new clothes, and a swanky new apartment as soon as they start their career.

Debt Sucks

Naturally, it probably takes someone a pretty long time (a few years?) to overcome the initial debt hurdle. Once the debt is cleared, a person can FINALLY start their path towards building wealth. For anyone who has had to overcome paying off large amounts of debt, the feeling upon finishing debt repayment is beyond liberating. It really does feel like the weight of the world has been lifted off your shoulders. And I’m sure the first thing these people say after winning the battle is:

“Never again! I am never going into debt EVER again!!!”

But Wait!

To dismiss all debt as “bad” or “evil” would be the wrong thing to do. Regardless of what mainstream media says, there is a difference between good debt and bad debt. Bad debt is easy to identify — this is the type of debt that we are all used to — the kind that will take you to poorhouse. Bad debt accumulates when you purchase things that are not assets, but liabilities (e.g. consumer debt such as: cars, season passes, fancy clothes, yachts, etc.).

Good debt is different. In fact, it really isn’t debt at all. Good debt has been such a powerful force in helping so many achieve massive amounts of wealth that is goes by an entirely different name — LEVERAGE.

The Decision

What makes leverage so powerful? I believe the best way for me to illustrate its awesome power is to use a real life example.

In early January of this year, the bank approved my short-sale bid to purchase Rental Property #2 for $290,000. Through the use of leverage, I did NOT have to come up with the entire $290,000, which would have been impossible for me to do at the time. Instead, I only had to put down 20% for the downpayment, and borrow the rest from the bank.

Still, even though I only needed to come up with 20%, I didn’t even have that! But I did have a dividend portfolio that was valued at just over $60,000. I had a decision to make. Do I liquidate my stocks to purchase this property?

Because I was only putting down $58,000 of my own cash, I had to rely on using leverage to borrow the remaining $232,000 from a lender. But without leverage, I wouldn’t have been in position to close the deal.

The Results

Hindsight is always 20/20, but even in early January, I knew that I got a good deal on the property. I was crossing my fingers everyday, hoping the short-sale lender would approve the sale. That’s right, I was praying the bank would say “yes” to lending me money.

To come up with the $58,000, I was forced to liquidate the majority of my dividend stocks. As we all know, the stock market has been on fire this year, and the S&P 500 and Dow Jones have hit historic highs. So, let’s say my stock portfolio was worth exactly $58,000 at the time of sale. Had I held onto the shares and not purchased the rental property, my stocks would of course be worth more money today. Let’s be extremely optimistic and say the shares would have appreciated by 30%.

That means the $58,000 would now be worth $75,400 today. That’s a tidy sum and a VERY handsome profit in only 6 months time. I’m sure many investors would be thrilled with that kind of appreciation.

In January, the property appraised for $290,000. Since that time, the property has appreciated to $420,000 (this is what nearby comps are selling for in July). That’s a return of 44.8%, which is just slightly more impressive than the 30% received from stocks.

At this point, you might be wondering, so what’s the big deal? You just got lucky and made a little bit more money.

Well, the big deal is that I didn’t put $290,000 into the deal. Through the use of leverage, I was able to do better than that. You see, I only put in $58,000 into the rental property. If I was to sell today, I would receive $420,000 (excluding agent commissions, taxes, fees, etc.). Once I paid back the bank their $232,000 loan (actually less, since the monthly mortgage has reduced the principal), I would pocket $188,000. In total, my $58,000 investment would have grown to $188,000. This is a staggering 224% return on investment!

Your Options After Profit

The above example clearly shows what a powerful tool leverage can be, if invested wisely. But it gets even better. By using leverage in real estate, there are actual tax laws in place that would allow you to pocket the entire $188,000 and not have a pay a penny in taxes! This simply isn’t possible with stocks. If you sell stocks, you’ll always be hit with some kind of capital gains tax (whether short-term or long-term).

Real estate is different. If you owned and lived in the property, you can capitalize on up to $250,000 ($500,000 if filing jointly with a spouse) without paying taxes. The only provision is you would have had to live in the house in two of the last five years, at the time of sale.

For an investor, you can shelter the profits from taxes by doing a 1031 exchange. You would simply sell the property, and roll over the funds to invest into a more expensive property. Potentially, you could have enough ammo to buy a commercial apartment building. These techniques are exactly what savvy real estate investors use to snowball their wealth and portfolio. And guess what? They use leverage to purchase that commercial building as well!!

Lines of Credit

But suppose you didn’t want to sell. Say you’re like me, and you really like the property you purchased. It’s located in a fabulous area, it cash flows on a monthly basis, and you are able to attract quality tenants without any effort. Let’s say you also feel like it could appreciate even more over the next decade. What could you do then, to access some of that equity tax free?

There are many ways, and I am looking into them as we speak. You could go back to the lender and ask for a cash out refinance. The bank would re-appraise the property (say it appraises now for $420,000), and you could redo your loan to pull equity out.

You could also apply for a home equity line of credit (HELOC). This works like a credit card, and the bank would open up a line of credit for you to use at your discretion. You would make re-payments that charged interest that fluctuated with the prime rate. But as a perk, the interest on the HELOC would be interest deductible.

Using a line of credit is a smart way to allow an investor to pull out equity out of an appreciating asset. The best part is the money you take out (say $40,000) is not subjected to any taxes.

It Almost Feels Like Cheating

Once the money is out, you are free to invest it anywhere. In the previous example, you could use the $40,000 to rebuild a dividend portfolio, or use it to purchase another rental property.

After that, you can easily imagine how this process could repeat itself, over and over again. Granted, there are ALWAYS risks involved when using leverage, and one has to perform the necessary due diligence to protect themselves. Nevertheless, it should be quite evident how leverage can be utilized to help a person amass wealth rather quickly.

I’ve saved up funds to purchase dividend stocks. I did it for a whole year. I’ve also saved up for the downpayment of a property on three separate occasions. It takes a long, long, long time to build up to even just $60,000. Especially since the majority of this money has to come from my employer, which is subjected to 40%+ in taxes! Without leverage, I would need many years (eons) to save up $188,000 in post-tax dollars. So, when the real estate market is down, and the deals are SCREAMING, telling you to BUY, you owe it yourself and your financial well being to use leverage so that you can take advantage of those “once in a lifetime” opportunities. Don’t be scared away from taking on a little debt. Just be careful, and remember the following:

“Leverage is a double edged sword that cuts sharply in either direction. Use it wisely, and you’ll be wealthy beyond your wildest dreams.”

{ 14 comments… read them below or add one }

1 JarkkoNo Gravatar July 8, 2013 at 6:25 am

You need to be a bit more accurate with your calculations! Maybe optimism carried you too far, but if you sell the house for $420 000 and pay back the loan ($232 000 or a little less), you most certainly don’t have $246 000 left! It seems you counted the original equity twice.

I’ve enjoyed reading the blog, keep it up!

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2 FI FighterNo Gravatar July 8, 2013 at 7:34 am

Jarkko,

Well, that’s sort of a bummer. 😉 The return drops to 224% then. I should have known that was too good to be true…

Thanks for the catch! I’ve corrected the statement.

Cheers!

Reply

3 The First Million is the HardestNo Gravatar July 8, 2013 at 6:58 pm

Leverage can be a powerful tool, but a lot of people get carried away and rely too heavily on leverage. At which point it can just as dangerous, if not more so than the more common types of debt.

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4 FI FighterNo Gravatar July 8, 2013 at 7:55 pm

Jay,

Right, leverage of course carries with it some risk, but the risk can be mitigated if you do your homework and make good decisions. Obviously, easier said than done. I just feel bad for the legions of people who will run away in fear as soon as they hear the word “debt”. Run the numbers. Look at the investment. It’s foolish to pass up on great investment opportunities purely b/c of some emotional reaction that’s been ingrained by the masses, or past experiences.

It’s also important to point out that luck happens when opportunity presents itself and you are prepared to seize it. Sometimes it takes courage and a re-programming of the brain to do things differently. It took me awhile to get used to the idea of borrowing money and going into negative net worth… But I’m glad I didn’t close my mind off to it, as I would have missed out on some great deals.

Take care!

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5 OscarNo Gravatar July 8, 2013 at 7:02 pm

Hi fi fighter that’s great I bought a house in 2009 in san Bruno and its going for much more but realestate takes time we both were lucky. I had a rental and sold it in 2007 my tenants owed me 4 months rent by the time I got them out and the house was destroyed so be careful not to over leverage . I wish you the best good luck

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6 FI FighterNo Gravatar July 8, 2013 at 7:58 pm

Oscar,

That’s awesome to hear! Congrats to you on making a wise decision during a time of most uncertainty and fear.

Thanks for sharing your story. I’m doing my best to be careful with leverage, but I’m definitely not afraid to use it either. If I find good deals, then so be it, leverage it is. As I’ve said before, I’ll go $1 million in debt if my deals help me earn 10% off that. $100k/year will have me retired in no time.

Cheers!

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7 MartinNo Gravatar July 8, 2013 at 8:06 pm

People are using leverage normally when buying their primary residence and they are not worried about it, so why not using the same leverage when investing (and no matter what the vehicle is – stocks or real estate)? They are scared but they already do it with their home.
Look at it from another perspective, if you are young, you have only little money available to invest and let long time do the compounding job. When you get older you have a lot of money, but very little time to compound. If you can somehow reverse it and have a lot of money when you are young and have a lot of time, then you can grow a lot faster. But how to do it? How to let compound $300,000 now for 25 years instead for 5 years only and have $300,000 instead of $10,000 for example? Well, leverage it! Do the same thing what you do with your primary residence.

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8 FI FighterNo Gravatar July 8, 2013 at 8:49 pm

Martin,

That’s a very insightful way of looking at it — I hadn’t thought about it like that before! You’re right, and it’s funny how people will sign up for a 30 year mortgage using 0% down or interest only loans (2007), but shutter at the thought of using debt for an investment, instead.

In the end, if you fail, and all this leverage blows up in your face, what’s the worst that could happen? You get foreclosed and lose all your properties. Your credit score tanks. So, what happens? You have no savings and have to work a 9 to 5 to support yourself… just like 99% of the U.S. population!

But if you succeed? You’ll be wealthy beyond your wildest dreams! Just like you put it, how many young people have the resources to really invest and make a dent with? Not many. Leverage gives you the power you need to really accelerate the returns. And it doesn’t have to be that dangerous either. Keep your 9 to 5 job, build up ample reserves, and even make mortgage payments in advance. How does this not help mitigate risk? I’m 3-4 months ahead on all my mortgage payments. Sure, I’m missing out on other investment opportunities by doing this, but it’s all about balance. This gives me the peace of mind I need.

Well, this whole leverage thing isn’t quite universally accepted. If all goes well, maybe I’ll write a book or do an interview someday. Be on the look out someday in the distant future 😉

Cheers!

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9 Pauline @ Make Money Your WayNo Gravatar July 9, 2013 at 5:53 pm

I’ve only ever had “good” debt and like you, would beg the bank for more if that was possible. That is awesome the HELOC is tax free. If you make a good buy you can almost immediately get what you put down out and buy something else. I don’t think it would work like that in the UK, although a friend of mine is doing refinances on his rentals for a bigger value, I’d have to look into that

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10 FI FighterNo Gravatar July 9, 2013 at 8:58 pm

Pauline,

haha, I feel the same way! My plan is to actually max out my 10 fannie mae loans as soon as possible. After that, I may need to use hard money to get funding.

HELOC’s are a powerful tool to help tap into existing equity. Lots of people find clever ways to use them to create infinite return deals. Basically, use a HELOC to buy a property all cash at 70%-80% of retail. Refinance later, and pull out enough equity to pay off the HELOC. All the cash flow and earnings after that are infinite since you have ZERO money in the investment.

Lots of clever strategies are out there. Leverage helps you make use of them.

Take care!

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11 TomNo Gravatar March 10, 2014 at 11:12 am

Good article FI. The one caveat I would have is that if you really are trying to save and you’re at the beginning stages of trying to achieve financial independence, I would say ditch the expensive car altogether and invest in the asset. If you’re pretty close to FI, then go for it, but at the early stages, every bit helps as there is a huge compounding effect on getting a car for $383/mo vs say $200/mo or less.

We’re actually applying this logic to our student loans. We plan on only paying off the loans that have 6% or higher interest, while I plan on keeping the loans I have at 2% for as long as possible.

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12 TomNo Gravatar March 10, 2014 at 11:18 am

Sorry the comment above was meant for your article here: http://www.fifighter.com/financial-independence/thoughts/2014/03/who-wants-a-shiny-free-toy-i-do/#more-9915

I just had both articles open in different tabs.

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13 NunoNo Gravatar March 15, 2016 at 8:07 pm

Hi,
I am finishing a finance degree.
It is a nice post. Debt is very useful.
However, I think you disregard too much the risks involved.
Selling a broad range of dividend stocks for an illiquid and concentrated asset may not be the best option even if the deal seemed good. Nevertheless, it always depends if you have more assets that guarantee a reasonable level of diversification (otherwise it is dumb) and also on your risk appetite.
Bear in mind that real estate may lose value and in that case you may find yourself in a difficult position. A 20% down payment is quite aggressive and will lead to loss of more than the capital invested if a severe downturn occurs.

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14 FI FighterNo Gravatar March 15, 2016 at 8:14 pm

Nuno,

Risk is relative. Leverage is your best friend in a downmarket and your worst enemy in an upmarket. Plan accordingly.

With that said, and with the benefit of hindsight, this deal turned out to be the best investment that I have ever made in my life. I would take this deal 1000 times out of 1000.

It helped me retire and quit my engineering job.

All assets can lose value and go down, that’s not exclusive to real estate.

Take care!

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