It’s All About the Leverage

We all want to have our hard earned money grow quickly. Initially, this feels like a fool’s errand. The effects of compounding and small percentage changes to our portfolio don’t seem to make any impact. No appreciable impact at least. You might do the math on your savings and investment rates and realize, “I’ll be super rich! Once I’m 78 years old….. There must be a better way.” Well, there is. And to understand how this works, we turn to an unlikely source….physics.

In physics, there are certain fundamental tools which can greatly increase the output. Think of a pulley or a lever. In each case, if applied properly, you only need to use a little bit of force to move a really heavy object. This is called leverage. Lever…..leverage….get it! (Physicists aren’t really known for their witty and clever names). In mechanics, these types of simple machines are combined in clever ways to make very complicated instruments. And these complicated instruments can do immensely more things than simply lifting a heavy object.  

In your personal finances, there are also levers you can lean on to get far greater returns. Instead of waiting for years and years to see the accumulation of gains and compound interest, we can start seeing the process at work in as little as months.

These tools are not completely risk-free, however. Just as in the case of using a pulley to lift a heavy crate increases your risk of getting hurt by dropping the thing on your head, financial leverage is a dangerous tool. In this article, we’re referring to the leverage of debt, or OPM (Other People’s Money).

Debt is a Double-Edged Sword

This tool cuts both ways, accelerating the gains, and also the losses. So make sure that you understand how to quickly pay off the debt, to reduce risk. But make no mistake, this is a powerful tool that is very often necessary to become wealthy quickly. There is no reason to fear debt as a concept. It is a dangerous tool, that must be respected. The self-made wealthy person learns to harness this tool safely and effectively. 

You are already participating in debt most likely. Even if you have no student loans, car loans, or credit card debt (good for you!), you are likely lending money to other people. This then becomes their debt. If you have any money in the bank, they are using that money to make loans to other people. They then get a return on that money and pay you a part of that as interest.

I also want to point out that there are many other types of debt, debt structures, and entire industries surrounding the concept of debt. In this article, however, we are strictly going to be focusing on the most common, stereotypical types of debt for the average American household.

As you get further along in your real estate journey, learning and understanding specialized debt structures will become paramount to rapidly scaling your real estate portfolio. For now though, let’s look at the most common types of consumer debt, also called consumer credit. 

Student Loans 

This is one of the most common types of debt, and unfortunately is now the second largest type in the US behind mortgage loans. Leverage is easy to understand here. You take a loan in order to afford an education. The bank charges you some interest as payment for using their money.

In theory, by getting more education, you will have increased the amount of money that you are able to make by just working during that time. And this increase in income should offset the extra money that you need to pay on the loan each month. This type of debt is necessary for many people in order to get a college degree. Depending on what you specialize in, this can often work out very well, but its best to minimize the amount of debt that you need to take on in order to accomplish any goal in life.

A huge disadvantage of this type of debt is that it cannot be discharged in bankruptcy. For most other debt types, and for all the other ones in this article, if you get yourself into a giant pickle, you can pull the financial ripcord by declaring bankruptcy and at least get a fresh financial start in life. It won’t be pretty or fun, but it is at least an option. 

This is part of the reason why the government and private banks are so comfortable giving anyone with a pulse a shitload of money to study whatever their heart desires. They will get their money back eventually, with interest, unless you die.  

On the path to financial independence, it is imperative that you get your income up. Getting a degree in a high paying field is a great first step, and student loans can be used to make that happen. If you have your heart set on a high paying industry in which a college degree is a requirement, then the path is clear. Use as little student loan debt as possible to acquire the degree rapidly, and then focus a plan to repay the debt very quickly. 

Auto Loans 

These loans suck. I have personally never had an auto loan in my entire life. There is practically no way that these loans are helpful for increasing your wealth, income, or chances at financial independence. “But what if I use the loans to buy a car, and then use that car to make money driving for Uber, or to buy a collectible car?” 

First of all, collectible cars don’t actually generate any money until you sell them, and is a gamble that the car will be worth more by the time you sell it anyway. Second, Uber is basically a low paying part-time job with few transferable skills, so I would argue that your time would be better spent learning more useful skills. Since you are using your own car, you accelerate the depreciation on your car.  

At the end of the day, that is the issue with auto (car, motorcycle, boat, blimp, etc.) loans. You are spending money today on the down payment, and continuing to pay money with interest for something that is no longer worth what you agreed to buy it for. Lastly, your car doesn’t generate any income for you. The return on investment is always negative.

Obtaining a large car loan is the quickest way to screw over your finances right out of the gate. If you need to get a car, save up enough money to buy a junker off of craigslist. As you start to make more money, you can upgrade to something more reliable, but only if you can pay for it in cash.  

So, the best way to use auto loans to get wealthy is to not use these loans at all. Drive an old beater. You can’t get much worse than my car! Given that there are very few jobs that require you to have a newer/nicer car, invest your money instead. 

Credit Cards 

Credit cards are really hated in the media, and for good reason. The interest rate on credit cards is extremely high. As a young person just getting started with credit, it is unlikely that your limit is very high. Therefore, most of the things you would be buying with credit cards are small expenses such as eating out, going to the bar, buying stuff at stores such as clothes, etc.

There is no reason to ever pay interest on credit cards to buy consumer goods and experiences. That being said, it is important to get a credit card as early as possible, and practice using it responsibly. Pay off the balance every month, or even every week. The other reason to do this early is to show lenders that you understand credit, and can use it responsibly. Achieving a high credit score early is very helpful in getting other types of debt, in larger amounts, and with much better chances of generating positive returns on the borrowed money.  

It is extremely controversial, and not something which I can recommend, but there are certainly cases where individuals have used credit cards to provide start-up money for their business. Generally, this occurs by putting inventory or marketing expenses on credit cards. Sometimes these cards have no interest for 1-2 years, reducing the risk. So it is possible, but extremely risky. 

Should you choose the dark side, remember, the name of the game is to use debt to purchase assets that will offset the cost of the debt. Have a backup plan, and stick to it. 

Personal Loans 

Personal loans are simply loans that you take out for personal needs. They don’t have a defined purpose and aren’t generally tied to any collateral. The interest rate on these loans is higher than secured/collateral based debt, and just like all debt, the rate will depend on your personal credit score. That being said, these can be a great source of funds. So long as you use the money from the loan to generate more income than the cost of the loan, aka the interest rate, you’ll make money. 

While these are generally less risky than credit cards, I only recommend that you pursue this strategy if you have a very short time-frame to pay your loan back. For instance, if you fix-and-flip a home over the course of 4 months, then it may make sense to take on short term debt in order to make this happen. As you stretch out the payment term, the risk goes up. If you lose your main source of income and fail to make the payments, then the house of cards comes tumbling down. 

If the spread on the debt or the difference between what it costs you to borrow and how much money you expect to make using the borrowed funds is really high, the risk becomes more worthwhile to take. As an example, let’s say that you want to build a small apartment complex. The project cost is $300,000 dollars, and the project will take 2 years. Generally, it is risky to take on a ton of debt like that over such a long time frame. But let’s say you partner with an experienced builder and investor. Let’s also say that the building is expected to sell for 1 million. It starts to become more attractive to leverage up.

Home Loans 

When you’re just getting started in building a buy-and-hold real estate portfolio, these types of loans can be the best options available to you. In this case, I’m talking about conventional financing. This can be as low as 3% down in some cases with very low-interest rates of ~5% at the time of this writing. This debt is collateralized by the house itself, so is relatively safe for the banks. That is why they will let someone take on a frankly absurd amount of debt relative to their income.

This is a win for us as real estate investors. A popular strategy in real estate investing is to simply buy a house every year, putting 5% down, and living in the property themselves for a year. If you buy an investment property, and not a personal residence, the banks require you to live in the house for at least a year. A year seems like a long time, but after 5 years you could have 5 properties by simply following this strategy. Even better, you can obtain a conventional property loan, with just 5% down payment, on up to a 4-unit building. So, if you buy only 4-plexes using conventional loans, you would be up to 20 units after only 5 years.

Use Loans to Purchase Assets

In summary, a very quick way to wealth is to use other people’s, including the bank’s, money. You have to start slower in the beginning and prove yourself worthy of using their money. Which is why I’ve encouraged the use of credit cards to build good credit. Once you’re able to get loans, use those to purchase assets. The best situation is where you can immediately pay the loan back, while still keeping the asset you bought. Once you master this, you will start to rapidly build your passive income, and be only a short distance from complete financial independence.