Debt is leverage. With leverage, you can do more.
For example, mechanical leverage occurs when the amount of force expended is amplified by a machine, tool or system. If you’ve ever used a bar to pry something out, you’ve used the principal of leverage to get more done. If you’ve ever sat on a teeter totter with someone who is much heavier or much lighter than you are, you know how the heavier person pulls the teeter totter down and the lighter person goes in the air. Then, when you changed positions so that the heavier person sat closer to the middle so you have reach equilibrium, you’ve used the power of leverage.
You may have heard about leverage in financial terms as well. It’s a popular topic for motivational speakers and business coaches. Sadly, it’s also used just as frequently by people who delude themselves into a mountain of debt under the impression that they are actually building wealth.
Good debt, or positive financial leverage, might be buying a piece of real estate for $100,000 with 20% down, or $20,000. The $80,000 debt is then financed with a 30 year fixed term mortgage of 4.5%. The overall return on the property is higher than the carrying cost of the mortgage, in this example, anyway, and that means assuming your other costs are in line and you can keep your property rented you have positive leverage. You have cash flow.
If you have 10 properties just like that, with the same amount of leverage and cost of financing and the same amount of income, you will make 10 times as much money.
Now let’s say real estate in general goes up in value by 10%. You can really see the power of leverage now!
If you have 10 properties worth $100,000 each, you have $1,000,000 in assets. If it goes up 10%, you just made $100,000, at least on paper. If you only had $100,000 to invest, you could finance to get the 10 properties, or pay cash and get one property, free and clear. The free and clear property is $100,000 and that’s your total asset amount. It goes up 10% or $10,000.
Leverage just increased your wealth by $100,000. Without leverage, it would have only been $10,000.
That is one of the secrets of real estate. It’s also the siren’s song that enticed so many people to invest, even with the cash flow didn’t make sense. They were betting that the increase in value would make up for the negative cash flow.
It did, for a while. And then it didn’t. That was 2008.
In general, the leverage was on property that had an unsound financial plan. As long as the market increased in value and there were lenders prepare to give you more money, increasing your debt and substituting as cash flow, you could stay in the game. And when it’s time to sell, you’re banking on the “greater fool” theory. In other words, no matter what you pay or overpay, there is always someone who will pay more.
But when the market turned down, the financial plan fell apart. For people who couldn’t stay the course, they lost the property.
The difference here is cash flow. If you have real estate that provides cash flow no matter what the market conditions, you have a much sounder plan than one that just relies on appreciation. Of course, appreciation helps the cash flowing property as well.
The moral of the story here is that leverage doesn’t make a bad deal good. Instead it amplifies whatever kind of deal you have. It takes whatever force there is, just like with mechanical leverage, and magnifies it.
With leverage, a good deal can be a great deal. And, with leverage, a bad deal can be a horrific one.
If you find yourself with a mountain of bad debt, there is something you can do about it. In January 2019, I’m launching a brand-new book “The Three Secret Ways To Pay Off Debt FAST.” I’m going to have a special low price in the beginning, so don’t miss out! If you aren’t already part of my mailing list so you can pick this book up fast, please go to https://www.ustaxaid.com/free-tax-updates/ and make sure you get the special link!
This is one New Year’s Resolution you can keep!