Financial leverage allows you to use a small amount of money and leverage it into an investment of greater value. Smart investors use financial leverage to create wealth. What is financial leverage and how can you use it to increase your personal wealth?  Read on to find out more.

Leverage is a powerful tool for creating wealth

Leverage is the use of debt to supplement an investment in order to purchase an investment of greater value, for example, think of the use of a cash down payment and a mortgage to buy your investment house. The mortgaged (debt) allows you to leverage your down payment into the purchase of an asset (house) of greater value than your original investment.

Elements of financial leverage:

• 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
• A stable asset to leverage for example, real estate.  This means that it is not generally subject to rapid declines in price
• Income from the asset, for instance rent, that you are using leverage to buy.  This ongoing cash flow decreases your holding costs
• Enough stable personal cash flow to support the loan repayments, if interest rates increase, or the income from the asset falls
• An 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 cash flow is not a good idea.

This article is excerpted from the book How to Regain Your Freedom, which will be available for download through this site in the near future.

Tags: OPM, Wealth

This entry was posted on Friday, April 16th, 2010 at 10:45 am and is filed under Wealth. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.