“Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”Archimedes
Is owning assets “free and clear” the best way to invest? After all, you have no interest payments and no obligations to anyone else. Why would you WANT to leverage your other assets or use assets as collateral? Well, the reasons may be more compelling than you think. Leveraging assets can be a boon to your wealth-building journey, done correctly.
In today’s article, we’ll address:
- Why “free and clear” isn’t all it’s cracked up to be
- Why the wealthy like to leverage instead!
- 3 ways leveraging can HELP you build wealth
- And why you must be cautious not to “overdo” it
The Myth of “Free and Clear”
Many people believe that if you’re debt free, you’re maximizing your money and avoiding interest. The myth of “free and clear” persists thanks to typical financial talking heads (just check out our Dave Ramsey review). And for the average person, this strategy may be fine. Yet is that how the wealthy of the world operate?
Just think about it:
- Why do wildly wealthy business people even bother seeking capital in the form of loans, the sale of company stock, or other financing options?
- Are successful real estate investors waiting to buy properties until they’ve saved every last dime, or are they utilizing mortgages?
- Do the rich of the world keep all of their money in a liquid/cash state so they have access to it, or do they put money to work, generating new wealth?
The answers are obvious, as is the conclusion:
The wealthy borrow against—or leverage—their own assets as a standard rule of practice. They do it wisely and cautiously, yet with an appreciation for how leverage can multiply their profits and let them control MORE assets than just the cash in the bank.
The Power of Leveraging Your Assets
Leverage helps increase the VELOCITY or “movement” of dollars through your asset. It helps you to do more with your dollars, and in turn, see results faster. When you multiply the JOBS your dollars do, you’re using strategies that multiply your DOLLARS, too!
Here are three reasons you may WANT to leverage your assets to increase the velocity of your dollars:
1. Financial Flexibility
Without financial flexibility, many investors tend to divide up their money in ways that make it inefficient, inaccessible, or both. They try to fund an emergency account, a 401(k), an IRA, an HSA, a 529, plus disability insurance, life insurance, and perhaps even pay off a credit card, too. The result? They end up having “too many accounts with not enough money,” as we discussed in our article on “Financial Flexibility.”
Having ample savings gives you safety, security, and the ability to respond to opportunities as well as emergencies. Yet who can afford to have 6, 9, or 12 months of living expenses parked in a savings account earning next to nothing? And how efficient will your savings be if you’re diluting it by paying into a dozen other accounts?
Having savings or assets you can leverage if needed means you won’t have to repeatedly deplete your savings account—or worse, your credit limit—when you need cash. Instead, you can keep your assets working for you while you leverage them. You can borrow against them to create financing for a new vehicle, a rental property down payment, or college tuition.
2. Increased Cash Flow
The ability to leverage assets can make an investment opportunity possible, or it can even make a good investment better. As Truth Concepts software’s Todd Langford explains in this real estate calculator tutorial based on a real-life example, leveraging the cash value in a life insurance policy might make a lot of sense when acquiring a cash-flowing rental property, provided that the cash flow is adequate.
Of course, another commonly leveraged asset is real estate itself. And while the mantra taught by many financial gurus is to “pay off your mortgage as soon as possible,” we can see from the following hypothetical example how paying off your mortgage can actually slow down wealth-building!
The Mortgage Example
If your goal is growth and cash flow, it may make sense to leverage. Let’s see how a mortgage might affect investment real estate from a wealth-building perspective:
Example 1: You buy a $200,000 property outright. From that property, you net $20k of cash flow (since you have to account for taxes, insurance, and maintenance). If you plug that into a rate calculator, you’ll see that $20k is a 10% annual rate of return. That’s pretty good.
Example 2: Now, let’s just say you bought that same $200k property with a loan. You put $40k down on the house, then borrowed the other 80%, or $160k. Thanks to the mortgage payment, you’re only netting $10k a year. That’s worse… right? Maybe not. When you plug it into the rate calculator, you’re actually making a 25% rate of return. After all, you only invested $40k of your actual capital. Even though you may be servicing a mortgage in this case, you’re still coming away with more bang for your buck.
Rate of return and cash flow are important factors on their own. Yet you have to look at the bigger picture to make the best choice for you. Many people are afraid of mortgages because they’re debt. However, this example shows that when properly utilized, they can do great things. You may also be thinking, “Who cares about the rate of return? The cash flow in the first scenario is still better!” Yet consider the initial investment. With $20k of cash flow, it will take 10 years to recoup the initial investment of $200k. If you only invest $40k and earn $10k, you recoup your initial investment in 4 years. After that, the $10k is pure profit.
3. Expansion of Assets
Let’s take this hypothetical mortgage example further. If your intention is to invest $200k into real estate, you could buy one property, as in our first example above. Yet let’s suppose you could buy 5 similar cash-flowing properties with 20% down, or $40k each. You would now have 5 properties earning $10k per year, for a total of $50k in annual cash flow!
Your rate of return would still be 25%, as in our second example above. Yet, instead of controlling one $200k asset, you’d be controlling FIVE $200k assets—or one million dollars in assets—with only a $200k investment!
Yes, you’d have five times the work, if you’re managing the properties yourself! Yet you would also have five times the cash flow. And at the end of 30 years (supposing a 30-year mortgage), you’d own five houses free and clear. At a modest appreciation rate of 4% over 30 years, those five homes could now be worth more than 3.2 million dollars!
Without the Leverage…
If you chose NOT to leverage your assets and instead only bought one home, you’d only have a value of about $650,000. While that’s certainly an improvement, it’s a drastic difference from $3.2 million. Even if you just invested the $200k in an account growing at 7%, you’d come out with just over $1.5 million. And that’s without taxes or 30 years of cash flow. When you consider that, the power of leverage becomes abundantly clear.
The ability to leverage is the reason studies consistently show a shocking difference between the net worth of homeowners and renters. And the gap continues to widen. In 2019, research from the Federal Reserve showed that the average homeowner has 40 times the net worth of the average renter!
A Consumer Finances report published by the Federal Reserve in 2012 showed a larger gap in net worth between homeowners and renters than between those of different education levels, locations, races, and even types of occupation. The only factor that appeared to be equally or more powerful than home ownership in terms of growing wealth, statistically speaking, was age. (Older people have had much more time to save and invest!)
Caution: A Warning About Over-Leveraging Assets
Just as leverage can make a good investment better, it can make a bad investment worse! If you actually owned five rental properties, access to cash is critical. You never know when you’ll have to pay for the occasional big-ticket item, such as a new roof or damage control from bad tenants. This is why investment real estate and whole life cash value can be so synergistic: you have liquid capital AND leverage.
Even with a well-maintained rental, if you over-leverage real estate so that it no longer has cash flow (perhaps counting on appreciation to make it a good investment), you may find that you have an unsustainable or even worthless investment. In 2008-2009, when the real estate market took a sudden downturn, many foreclosures were a result of such speculation.
Similarly, if you under-capitalize a business or leverage against your stocks to purchase more stocks and there is a severe decline, you will magnify your losses, potentially even losing more than you started with.
However, just because you must leverage your assets carefully doesn’t mean that you shouldn’t do it! (That would be like saying we shouldn’t use furnaces, heaters, or wood-burning stoves because they can burn down a house.) No, we must exercise caution by paying attention to cash flow, capital reserves, and not speculating on returns.
Should You Use Assets as Collateral?
Borrowing against your assets, whether a home, a business, a life insurance policy, or any other asset should be done with care. The wealthy put their dollars to work, while also maintaining ample liquidity they can tap into if needed for major purchases, emergencies, and new investment opportunities with reliable returns.
The bottom line is clear for those with ears to hear: leverage is a simple yet powerful strategy that you neglect at the peril of your wealth!
If you want to leverage your assets, go slow and start small. Make sure you have ample cash reserves. Do your due diligence, and work with people you trust.
Want to build your cash reserves? We’d be more than happy to help you with a life insurance policy, so you can grow your liquidity with certainty. Set up a meeting with us today, or email your questions to firstname.lastname@example.org.
Disclosure: Our content is meant for educational purposes only. While it’s our goal to help you learn about building a life of prosperity, we do not intend to provide financial advice. Please consult your financial, tax or legal advisor before making any investment or financial decisions.