The wealthy do things differently than the masses. Yet, most people don’t follow the lead of the wealthy, which is why there is a huge disparity, ever widening, among the rich vs the poor. Therefore, to engage in true wealth building, a re-education, including a proper understanding of money and financial leverage using good debt, is essential.
Most people will say they understand leverage, but then they’ll work hard to pay off their mortgage and let the equity in their home sit unused, even though the return on your home’s equity is zero. It’s one thing to know what leverage is in theory, and it’s another thing altogether to put it into practice in your life.
Financial leverage is the tool of the wealthy. It’s the way in which you can turn the fractional reserve banking system in your favor.
With $1,000,000.00 invested, earning 7% per year, the return is $70,000. Simple math. And for those that are struggling every year to get ahead or plan for retirement, this scenario sounds really attractive.
The truth of the matter is that many people see a 7% return on their investment portfolio and think they “earned” $70,000, but in reality there are fees and taxes that will eat into that return. The end result, is that they’re more likely to “earn” $30,000 after fees and taxes.
This is the perception of the masses on the money secrets of the wealthy and how they earn their millions. The masses believe the wealthy have millions of dollars in various investments, and because they have so much money invested, they earn a lot of money each year. That’s not the typical situation, and let me show you why.
Financial Leverage Example
Let’s take the scenario above, and see how we could earn far more money with our $1 million.
Instead of using the $1 million to invest in the stock market, you could take the $1 million (preferably as a policy loan from your cash value life insurance) and purchase 10 properties with 20% down, which is a financial leverage ratio of 5-1.
(I’m using real estate wealth building strategies in this example, but you could also purchase oil wells, coffee plantations, and more.)
The ten properties are each worth $500k, for a total of $5 million. In this scenario, you are using the $1 million as leverage to invest in $5 million worth of real estate investment property. The additional $4 million financing comes from debt in the form of other people’s money (OPM).
If the property rises in value in the next year, say by 7%, your total investment return is $350,000. Once again, the financial leverage ratio is 5 to 1 in this scenario, which means you earn 5x what you would have without leverage. ($1,000,000 invested with a return of $350,000 is a 35% return on your money thanks to OPM and Leverage.)
Of course, leverage goes both ways so it pays to be prudent. But that is why we like real estate because you have renters paying your mortgage so that even if the housing market declines you are able to wait it out.
So in comparison, in our example above, $1,000,000 earning 7% in an investment account made you $70,000 pre-tax dollars. In contrast, in our financial leverage example, leveraging that same $1,000,000 we were able to earn 35% or $350,000 on the same principle investment amount.
You might ask, “Hold on! What about all the interest on the loans you’re paying!”
And you would be correct, there is interest on the loans. But keep in mind that these properties are producing positive monthly cash flow income. The cash flow from the properties should cover the cost of carrying the mortgage.
Other Factors to Consider
There are some other factors to consider in this scenario, like property management costs, or fees associated with maintaining real property, a plantation or an oil well. But the principle remains the same, and the wealthy use their money in such a fashion all the time because they know financial leverage is the most powerful tool they have in their toolbox.
8th Wonder of the World
Einstein said compound interest is the eighth wonder of the world. But based on the example above, we can make the argument that financial leverage is the eighth wonder of the world.
A word of caution
The principle of leverage is incredible in an up market, but it works against you in a down market if you’re not invested wisely. So you have to be careful with your investments. We recommend only investing in properties that are cash flow positive.
The reason to focus on properties that are cash flow positive should be obvious, we don’t want to be worried about down markets. If the housing market tumbles for 5 years, we don’t want to be worried about paying our bills. If the consistent income from the assets cover the cost of owning the asset, you can still weather a down market.
So, that’s the principle of leverage at work. But keep in mind that we’re talking about good debt here. Good debt is used to buy assets that appreciate in value and earn consistent income.
But wait, there’s more…
Having said all that, it may be enough to convince someone that they should use debt to buy cash flow producing assets. However, the story is even better for those that choose to leverage their money. To explain what I mean, we need to talk about one of the largest forces working against savers in the world today – INFLATION.
Inflation rates are thrown about here and there, but it’s pretty safe to assume that you’ll find them in the 3-4% range over the long haul. Inflation means that $1 today, is worth 3% less next year. When I say worth less, I mean that the $1 can purchase 3% less than it did 1 year earlier. The reason this happens is because the cost for goods and services is constantly rising.
So how does inflation play into financial leverage?
When you use debt or leverage to purchase an asset, you are buying the asset with future dollars. (Stay with me here, this may be a bit complicated for those that are new to the concept.)
Due to inflation, money has a constantly changing value, it is constantly depreciating. This is what I mean by the time value of money.
Time Value of Money
The best way to introduce the time value of money concept is by way of illustration. Let’s talk about buying a car.
Nelson Nash, the creator of the infinite banking concept, says that you finance everything you buy.
So, you essentially have three options when buying a car. You finance, in which case you pay interest to the bank. You pay cash, in which case you lose the opportunity to earn interest on that cash. Or you borrow from yourself, i.e. borrow against the cash in your life insurance policy, and pay yourself interest.
You see, if I pay you for a car in all cash, I am giving you the maximum value of my dollars. They are dollars valued today, without the diminished effects of inflation over the long term.
If instead, I choose to finance that car, I am promising to give you future dollars (those that are worth less) for the same car. In other words I am giving you less, because the money is worth less (due to inflation).
Think about it, that is why banks charge interest, because they want to be able to make more than the inflation rate.
So, when you see an opportunity to buy a car at 0% interest, it is to your advantage (assuming you have to get a new car instead of a used one), because you will pay the same amount, but you will pay it with dollars that are worth less due to inflation.
Let’s use some numbers to see how this works out. If the car is $50,000, and you purchase it with a 5 year loan at 0%, you will have to pay $10,000 each year for five years.
If you had paid cash, you would have paid $50,000 today. In other words, the money today has $50,000 worth of purchasing power. If you finance that money, you put the time value of money to work for you. Here’s how:
To keep our math simple we’ll do our calculations annually. Remember in our example we are using 3% inflation rate. Let’s break it down:
Amount Paid: $10,000
Value of money: $9,700
Amount Paid: $10,000
Value of money: $9,400
Amount Paid: $10,000
Value of money: $9,100
Amount Paid: $10,000
Value of money: $8,800
Amount Paid: $10,000
Value of money: $8,500
Total Amount Paid: $50,000
Total Value provided: $45,500
This is a rather crude example of the time value of money and inflation, but you get the point.
You are getting a car worth $50,000 TODAY, and you’re only giving the bank $45,500 in purchasing power.
As you can see, the wealthy understand the time value of money and they use it along with financial leverage to make the most of the current banking system.
30 Year Mortgage
In the example above we looked at a 5 year loan on a car. Imagine how that same principle can work over the course of a 30 year loan, where the amount borrowed is significantly larger.
This is how the wealthy game the system. A bank may be earning 4% on your home loan, but they may be paying 3% back due to inflation.
And when you factor in that you get a tax deduction on all interest paid, you further take advantage of the banking system.
Now some people may say “It doesn’t matter how much it’s worth, I still have to pay the same amount.” These objectors don’t understand what is going on here, so let me explain further.
In addition to the time value of money, there is an opportunity cost to paying cash.
When you pay with dollars today, you are paying with dollars you could have spent elsewhere.
If instead you chose to finance a car with a 0% loan you can use the cash to invest in something else that will grant a return.
So the opportunity cost of buying a car with cash, is the lost investment return you could have made with the cash used elsewhere.
Let’s look at our previous example:
Instead of buying the car for $50,000 in cash, let’s assume you put the $50,000 into an inexpensive rental property.
The $50,000 represents 20% down on a property that costs $250,000. This property earns income monthly to pay the loan payment, and to cover the cost of maintenance and taxes each year. At the end of the year, the property is worth $257,500 if we assume a paltry 3% increase in the home’s equity.
If that continues for 4 more years, at that low appreciation rate of 3% annually, the total value of the property after 5 years is $289,817. That’s roughly a $40,000 increase in home equity over 5 years. (The actual historic rate is somewhere closer to 4-5%, depending on location.)
So the opportunity cost of paying all cash for the car instead of financing the car at 0%, was a whopping $40,000, or an 80% return on the $50,000 over the 5 years. (And we are not even factoring in write offs, deductions, depreciation, etc.)
Real Estate Wealth Building
We have an article that covers real estate wealth building strategies, but imagine your potential returns if you financed your property 100% using other people’s money.
If you use the cash value in your life insurance policy as collateral for a loan, you can borrow your 20% down payment. Then you get bank financing for the remaining 80% via a 30 year mortgage.
But wait, there’s more…
You now have an investment that is fully leveraged. Your money in your policy is still earning dividends and interest, while simultaneously making money in your investment property.
Finally, you pay back your personal banking system with the cash flow from your rental property to complete the cycle.
The wealthy individual knows how to put their money to work within the current banking system, and make more money.
They understand the time value of money means that they should defer payment if possible.
They know that financial leverage means they can make more money if they have properly structured debt working on their behalf.
And they know that those that buy large purchases with cash, do so at an opportunity cost that should not be paid.
For more on how you can utilize a properly designed life insurance policy as your own banking system, please give us a call today for a free strategy session.