Leverage: The Key to Amassing Massive Wealth

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.”

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NunoReal Estate Investing: My Golden Ticket to Early Financial FreedomTomI’m 28 Years Old, Control $1,000,000+ in Assets, and am $578,740.76 in Debt!Pauline @ Make Money Your Way Recent comment authors
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Jarkko
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Jarkko

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!

The First Million is the Hardest
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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.

Oscar
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Oscar

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

Martin
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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.

Pauline @ Make Money Your Way
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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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[…] are so high. But that’s just temporary. As readers are well aware, I’m a huge fan of leverage because I believe it’s what will ultimately set me free sooner than later. Even better, even […]

Tom
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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.

Tom
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Sorry the comment above was meant for your article here: https://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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[…] for starters, it’s the whole concept of leverage. As I’ve written before, leverage is a double-edged sword that cuts sharply in both directions, but for the risk-takers out there, if utilized correctly, it can shortcut your path to financial […]

Nuno
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Nuno

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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