Smart use of leverage is a common factor in the life of many wealthy people and helped many on the way to financial freedom.  What is leverage and how can you use financial leverage to increase your wealth?  Read on to find out more.

Leverage is the use of other people’s money.  The principle is like that of a lever to lift a heavy object, you let the lever multiply your small effort.

The successful ingredients are:

• An asset that you can borrow against
• A line of credit or loan from a bank at a reasonable interest rate
• Ability to claim interest payments as a tax deduction
• Some income from the asset that you are using leverage to buy.  This cuts down your holding costs
• A stable asset to leverage.  This means that it is not subject to rapid declines in price
• Enough stable cashflow to support the loan repayments, even if interest rates increase, or the income from the asset falls
• A higher overall return from the property than the holding costs (after tax and any income)

Here is an example of how you can convert income into wealth using financial leverage:

• Ms A has an income of $150,000, achieved by carefully managing her career, investing in her own skills.  She has managed her expenses, leaving a surplus of $50,000 per annum after tax.
• Ms A has saved $50,000 and has this amount in cash.
• She takes $20,000 and uses this as a down payment on a $100,000 investment apartment.  She bargains hard and gets a good buy.  She anticipates a $10,000 increase in value per year.
• She borrows the remaining $80,000 from the bank, using the investment apartment as security.  The interest rate is 10%, so she pays $8,000 per annum in interest
• She rents the apartment and nets $5,000 per year (after expenses) but before the loan is repaid.
• The apartment loses $3,000 per year (the difference between the expense and the income)
• The $3,000 is tax deductible.  After tax, it costs $1,500 to own the property.
• After one year, the property increases in value to $110,000, an increase of $10,000.
• Leverage has multiplied Ms A’s wealth.  Her $20,000 is now worth $30,000, for a cost of only $1,500.

Most wealthy people draw a distinction between their income (which they see as cash flow) and their wealth.  They have learned to convert income into wealth through investment.  Leverage is one of the tools they use.

Borrowing for consumption purposes, such as going into debt to buy a new television is not leverage and does not increase your wealth, or freedom.  Remember that borrowing without cashflow is not a good idea.

Tags: investment, wealth

This entry was posted on Wednesday, March 3rd, 2010 at 9:10 am and is filed under Wealth and work. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.