The concept is easy to understand but remains elusive to most. It moves our everyday lives—at home, at work, and through personal interactions and business transactions.
More often than not, it is used against us, without us even being able to acknowledge how or why. The wealthy understand and are often envied, because they use it to create legacies of financial freedom.
So, what am I talking about? LEVERAGE.
Leverage: (verb) To gain advantage through the use of a tool. (noun) The power to influence results.
In financial context, leverage is the use of borrowed money to make an investment and the return on an investment. For the sake of this article, we are focusing on how leverage is commonly used against the better interest of the general public and how to turn that leverage to serve you instead.
Notice that I talk about wealth and don’t use the word rich. I personally find the word rich to have an envious and derogatory connotation, which translates into a poor-man’s thought process. Wealth is about abundance, and the abundance we are talking about is income generated from leveraged money, NOT from time spent performing for a wage. This in turn allows us to take true ownership of our life.
How Banks Use Leverage
You Make the Money
Think about the lifecycle of a dollar. You go to work and earn a wage based on productivity, using a set of skills. The employer’s leverage on you is a guarantee of payment.
Some companies have additional leverage in the form of health and retirement benefits. Assuming you have an account with a bank, payment is made to your financial institution and then made accessible to you in the form of cash, check, ATM, debit card, etc.
You Bank the Money
In return for the “safekeeping” of your money, banks may give you a “free” checking account. Read the fine print though: Most have fees associated even with “free” accounts. If you’re lucky, you may get a savings account that pays you a whopping 0.06 percent interest rate. This is the national average. You may even get access to a CD that pays 1 to 2 percent over the course of a year or three.
Banks Make Money Off Your Money
In return, the bank is granted access to use your money to make their company’s profits. How they do this is simple.
Most people rely on the bank for a mortgage, car loan, credit card, etc. They use your deposits—which they are paying you peanuts for—and loan it out at spreads that are 50 to 100-plus times over. For every mortgage they approve at 4.25 percent APR, they are making the difference between that and the measly interest rate they give you on your savings account.
Related: A Whole New Way to Look at Leverage
Add in all the fees, and you are actually losing money by keeping it the bank. Banks are the most common example of how leverage affects us every day.
Leverage is also a huge part of all types of businesses, like insurance, asset managers, medical and medicine, education, etc. It’s a factor in just about every business known to man.
Why Many Individuals Lack the Ability to Leverage Their Own Money
Being house poor is the first and biggest reason most people are not able to put their money to work. How? Why?
The banking world likes to use the term debt-to-income ratio, or DTI, when it comes to issuing you a loan or credit. This is the amount of debt their algorithms say you can sustain relative to your income. The banking world teaches us that it’s OK to have debt up to 43 percent of your gross income.
Notice the operative word: GROSS!
The theory is that if you make $5,000 a month in gross income, then you can afford a mortgage payment of up to $2,150 a month. This assumes you don’t have a car payment or credit card debt, which we know isn’t true for most.
If you fell for this nonsense and bought your own McMansion—and are also financing or leasing a new car or two—then please keep reading.
The problem with borrowing based on gross income is that once you receive your actual net income, you barely have enough money to pay your bills and buy food, let alone add pleasure and leisure to your life.
And investing? Nope, you are relegated to the types of investments that you can’t touch without big penalties until you “retire.”
Then, we get to credit cards and other forms of credit, like home equity lines of credit or loans. What do most people do with these? If you guessed spend it on their house, you would be correct.
Work, Work, Work
The logic that your 401(k), social security, and (if you’re lucky) pension funds will cover your retirement is a great con. This cycle all but guarantees that you will need a job ’til you reach that ever-moving end target of “retirement age.”
I’m here to tell you that it’s never too late to make a change.
The first change starts with mindset. Think of every dollar as an employee. Are they doing productive work or draining work? How can you maximize the output of every dollar to build passive income?
How to Flip the Script
First, get lean. No, I am not talking about dropping some pounds or going to the gym. I’m talking about evaluating your income and expenses.
Put more dollars to work making money than helping others make money. This means going through your bank and credit card statements and looking for subscriptions, memberships, and habits that you can reduce or do without. A great example of the lowest hanging fruit for most is the cable bill.
Reduce, cancel, close, stop!
Related: 5 Pillars of Wealth-Building All Savvy Investors Should Consider
Reduce or Eliminate the Biggest Money Suckers
Next are the big-ticket items that may take some time to fix. That is your mortgage and car payments. It’s time to consider refinancing or even downsizing.
As for car payments, most car depreciation (loss in value) happens in the first two years. By buying cars two-plus years old, you can drive a nicer car than what you could otherwise afford new. And by driving these cars for at least 10 years, you’ll be breaking free of another societal lever meant to keep us all stuck on the track of continual consumption.
Getting lean might also include paying down credit cards, lines of credit, etc. You will need the whole house to support your efforts through some perceived short-term sacrifices, so be sure to get everyone on board.
Something else to consider is reallocating contributions to funds that are long-term in nature. This includes IRAs, 401(k)s (above employer matching amounts only), 529 plans, etc. Consult with your financial planner on this.
I’m not afraid to say this, because I consider real estate investing as safe—if not safer—than many retirement plans. This is because we can access the money while we invest it to accelerate growth. Not to mention the rules can and will change with government plans.
Identify Sources of Leverage
In order to start building your passive income streams, identify your sources of leverage. The rule of thumb is to identify cash first, then no-cost or cheap debt (money you can access at 6 percent interest or lower). When used to generate money we call this “good debt.”
Once identified, you will use this money to build passive income that you can use now—not when you’re 65 (or 67, or 70).
Some examples of leverage sources:
- Cash from income and savings
- Cash from passive income (more on this in a bit)
- Borrow your own money (401(k), whole life policy, etc.)
- Other low-cost debt sources (home equity, lines of credit, promotional offers, etc.)
In all cases, we will be using money as a down payment, not for a full investment.
Be careful if using accounts with an adjustable rate. You need to be sure you’re able to pay down the debt from the passive income. To stay within conservative estimates, you’ll want the difference between the interest and return rates to be at least 3 percent.
Something else to consider is the strength of your ability to access leverage. For example, someone with a long history of W-2 employment and good credit will more easily qualify for credit than someone just starting in the workforce, rebuilding credit, etc.
Use Leverage to Build Wealth
Now that you’ve established your source(s) of leverage, it’s time to put it to use. If you’re guessing that this is where I talk about investing in real estate, then you are catching on.
Let’s model a strategy that many other investors and I have used to grow passive income and net worth. Suppose we’ve been able to cobble together $25K to start our wealth journey. Real estate is one of the few assets that can be leveraged in multiples. This means that I can acquire and control a property worth $100K with $25K.
We’ll leave out closing costs to make the example easier. There are many other ways to buy with even less, but that’s for another post.
How Individuals Can Leverage Money Through Real Estate
The following is an example of a solid investment. We will be using some common rules for how a property should perform.
- Property cost: $100,000
- Down Payment: $25,000
- Monthly Rent (1% Rule): $1,000
- Monthly Mortgage (4.25%, 30 Years): $370
- All Other Expenses, including Property Taxes, Insurance, Utilities, Maintenance, etc. (50% Rule): $500
- Net Operating Income: $130/month
- ROI: $130 x 12 = $1,560 / $25K = 6.25%
Something to keep in mind when you consider that 6.25 percent return is that you will be deferring taxes on that money, and it doesn’t consider the appreciation rate of the property. This means that the actual return is closer to 8 or 9 percent or higher.
Better than that CD return of 1 to 2 percent, right?
The above example is using some real estate rules of thumb that are considered the most conservative. This is to ensure a positive cash flow every month.
The reality is that there are many ways you can drive down expenses and maximize rents. Assuming you have a property that operates in the low 40 percent expense ratio, which is my conservative target, you can get a cash flow of $200 a month. This comes out to be $2,400 a year.
Not a bad raise for putting your dollars to work.
Your Next, Next and Next Investment
Your next property will still require cash and leverage, but getting the first one done is the most important step. The one thing I hear with nearly every investor who I have ever worked with is, “I’m ready for the next deal!”
Yes, you are.
Let’s say your next deal is similar to the first, and you generate another $200 a month. Now your passive income is $4,800 a year.
Here is where we return to leverage. The secret is to leverage the appreciation and value of your existing holdings, while increasing rents to ensure the passive income on those properties is not reduced. Eventually you can sell and trade (1031 exchange) these properties for larger properties that produce even greater income—all while continuing to reduce, defer, or eliminate taxes on the income through the depreciation and deductions of property taxes, insurance, repairs and maintenance, etc.
Mind you, this is a physical asset that you can touch and feel, not just assume exists because a statement says so.
This is the power of LEVERAGE! The formula is simple; use it to compound money and income to pay down the debt for reuse.
It’s our mindset that needs to change. Model these wealth-building strategies and refuse to stay stuck in the rat race that benefits everyone except you.
Are You Ready to Start Using Leverage?
My hope is if you’ve read this far, the word leverage has struck a nerve. Hopefully thinking about it triggers some action.
I personally know many people who have convinced themselves that real estate investing is out of reach—or worse yet, that the path they are on is comfortable and they don’t need any more diversification in their financial planning.
The reality is that leverage is a very powerful force, and most people have plenty at their disposal. It doesn’t matter if your goals are your own financial freedom, security, retirement, saving for your kid’s college or first apartment, or just being able to pass down what you’ve worked for. It’s a matter of creating a strategy that puts your capital and leverage to work.
Ask yourself, why not put it to use to live now instead of sometime down the road?
Have you started using leverage to build your nest egg? How so?
Share in the comment section below.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
