Do You Know the Important Difference Between Debt and Leverage?
We have already discussed how many college students in the U.S. will graduate with student debt of over $100,000, with many closer to $200-250,000. The total amount of outstanding student debt is over $1.6 Trillion! There are also record amounts of personal debt over and above this that the average American has between mortgages, car loans and other loans and lines of credit. The vast majority of this debt has been used to purchase personal homes and consumer goods, like cars and electronics. Very little of it is investment debt, also called using leverage.
The Incredible Power of Leverage
Leverage is when money is borrowed to invest, with the expectation that the profits made will be greater than the cost of the interest of the loan. It is not used to purchase personal items. This difference is what separates the wealthy from most people. The wealthy are not against debt, they call it leverage. Rather than use their own money to purchase an investment, they borrow the funds at a low interest rate they have negotiated and are able to make much larger investments.
For example, if an investor had $100,000 to invest, they could purchase an investment property for $100,000. Real estate has historically grown at about 3% per year. A good investment property will also produce around 10% in rent as cash flow. So, our investor’s $100,000 would produce $3,000 a year in increased in equity in the property and $10,000 a year in rent for a total of $13,000 or 13% per year. Naturally this is gross and there are expenses to be paid like property tax, management fees, utilities, etc. It is realistic to think that after all expenses, the investor would net out $5,000 per year in rent, keeping the full $3,000 in equity, making 8% per year. This is still a pretty decent return.
If another investor used leverage however, the numbers change considerably. This investor could use their $100,000 as a down payment and purchase a property worth $300,000. This is a conservative estimate of putting down 1/3 of the value of an investment property. Many properties can be purchased with 20% down or less, meaning the $100,000 could be used to purchase a property worth $500,000.
Using the 1/3 down example, the investor could purchase a property worth $300,000, borrowing $200,000 as an investment mortgage. This is where leverage really shows its power. The investor now has the benefit of the same 3% growth in equity, but it is now on $300,000, so $9,000 per year. The rent would be $30,000 per year. There is the added variable of the mortgage, however. A 30-year mortgage at 3% would cost about $842 per month or $10,100 per year. The rest of the expenses would probably be $10,000 per year (expenses do not go up at the same rate as the value of the property), so the investor would still receive $10,000 net rent per year, plus the increase in equity of $9,000 for a total of $19,000 per year.
The net return is now 19%. As the years pass and the mortgage gets paid down and rents go up, that number will be substantially higher. In ten years, for example, the property might be worth $400,000 based on 3% growth per year and the rent will be proportionately higher. Yes, expenses will go up too, but the property will be earning based on its higher value, all for the same $100,000 initial investment. Also, in 10 years, the mortgage will have been paid down to $150,000 creating another $50,000 in equity.
At that point the initial $100,000 would be receiving $12,000 per year in equity growth (which is already 12%) plus gross rent of $40,000 per year. After the mortgage payments of $10,100 per year and expenses of say $15,000 per year, the net rent is still $15,000 per year. The total return would be $12,000 plus $15,000 for total of $27,000 or 27% of the initial $100,000, a great return. The investor will also have $150,000 in equity in the property, the initial $100,000 plus the $50,000 paid down in the mortgage.
To compare with the first investor, in 10 years the $100,000 property will probably be worth about $135,000. It should increase in value 3% or $4,100 per year. The rent should be approximately $13,500 per year with expenses of $7,000 per year. The net return would be $4,100 plus $13,500 minus expenses of $7,000 for a total of $10,600 or a 10.6% return, quite respectable. They will also have the full value of $135,000 as equity.
Both of these examples have been simplified and are theoretical but are based on very realistic scenarios that the wealthy are investing in every day. While the numbers can be complex, and there is naturally much more to property investing than buying and receiving rent, including taxes, the numbers are clear. If you can find a good investment that produces more of a return than it costs to invest, leverage can make your money and net worth grow at a much higher rate than straight investing.
Also, if you are investing your money and borrowing to make more money rather than to buy things, you can put your money to work for you in investments that will increase in value rather than watch it disappear as the things that are bought decrease in value.