Uncertain times As we went through in last week’s post the economy, the environment and our biggest source of energy are in unexplored territory. No one can know exactly how...
Using leverage is something that we all do on a daily basis. Leverage is what we might call a power-multiplier. With small power you can do something that takes a lot more power to do. This works the same in the financial world, and many people use it without understanding how it really works. Then some get crushed by a power that they can´t handle.
How does leverage work
Let’s say you are cutting your nails using a nail cutter, if you use a nail cutter for toes it´s a lot easier to cut your nails, why is that?
Because it´s “bigger”, right?
And because it is bigger it also means that you get more leverage (power) to the front of the nail cutter, making it easier to cut through the nails.
Have you ever tried to press in the middle of the nail cutter trying to cut the nails?
It won´t work, right? Or at least you have to press a lot harder.
The closer to the nail you press, the less leverage you get.
How does leverage and money come together?
This is the cool part, and also the part where some people get crushed. You want to be the one controlling the nut cracker and not the one getting your nuts cracked.
Most people are buying their home using leverage, they are using other people’s money (usually the banks) as leverage to their own money. We only need a small amount of money to buy the home because a bank will lend us the rest, in similarity to the nail cutter where we only need to press it a bit and then the leverage will multiply the power and cut off the nail.
Financial leverage could crush you
If you don´t understand financial leverage the outcome could be a catastrophe.
In the last downturn in the real estate market many people got crushed because they believed that their home is an asset when in fact it´s a liability. In Spain for example people bought apartments and houses because the prices were rising rapidly and they thought that this “asset” would make them rich. So to make it easy, say someone bought an apartment for 100.000€ and got a 90% loan. That means they only put in 10.000€ themselves then the bank paid the rest. Now if the prices would have kept rising like they did the years before, maybe 10% or more that means that the price of the apartment would be maybe 110.000€ the next year. Now because this person used leverage and only put in 10.000€ himself while the price increase was 10.000€ he would have made a 100% profit on one year, thinking that this real estate thing is awesome!
Thoughts would be running through his head saying something like this: “Being Donald Trump is not rocket science, you just buy a shitload of real estate, then wait for time to double your money every year and then puff, you´re a billionaire.”
But maybe there was more to it?
What happens when prices move in the other direction?
When (because it´s never a question of IF) that happens, the fairytale becomes a nightmare. When prices fall, they often do that more rapidly than they have risen. In a couple of years the 100.000€ apartment might only be priced at 70.000€, or even less. This is the danger with financial leverage combined with lack of financial education. This person not only lost all his money but are now in debt 20.000€ more than the current price of the apartment he holds. In situations like that the banks can get into financial trouble and that lowers their credit ratings making the interest on the loans that they take more expensive. In extension that forces them to increase the interest rates for the loans they give to their customers. This in turn does that some people can no longer afford to pay the interest on their loans and are forced to sell and take a loss. Some people stick it out but because more people need to sell the prices fall even more and it all becomes a bad circle, getting back to the banks going into even deeper trouble which lowers their credit rating even more.
So to speculate is one thing, you have to be aware that you could lose your money. To speculate with leverage is really dangerous and at some point you might get crushed so hard that you won´t have the possibility rise up again.
I know speculating with leverage is NOT a good idea, I have tried it. Sometimes it works and sometimes it doesn’t, and when it fails, it hurts, really much. Giving up the system of passive incomes is a stupid thing and I won’t do it again.
How the financially educated use financial leverage
I´ve written about this a couple of times before but maybe not from a leverage point of view. You already know that smart investors invest for passive income over the long-term because life is like a marathon, not a sprint. Running a sprint, or making a quick buck won´t take you anywhere, really.
One way to run a bit quicker in the marathon of life is to use financial leverage as a smart investor. Our money on pocket in the beginning is often pretty limited, of course but to illustrate the power of financial leverage in a different way, let´s use the example of buying an apartment again.
Now we buy the apartment without leverage, we buy it cash 100.000€ from our own pocket, how did we get 100.000€? I don´t know, maybe we won the lottery or something, it doesn´t matter. We bought the apartment cash, and started renting it out. The rent that we get in after everything is paid for is maybe 7000€ per year. Sweet, we now have a 7% return on our investment (7000/100.000=0.07=7%) and that’s great.
Now let´s see what happens if we use the same leverage that we did in the last leverage example. So instead we pay 10.000€ ourselves then the bank pays the rest, and we pay the bank interest for this service. Now maybe we instead of making 7000€ after everything is paid for we only make 5000€ per year, a 5% return on the total amount invested. But now the magic of financial leverage kicks in, since we only invested 10.000€ of our own money the return per year of 5000€ is now 50% (5000/10000=0.5=50%). After just 2 years we have all our invested capital back and are ready to make the same thing over again.
If the same thing happens again with the real estate market, our profits might go down a bit if interest rates go up but on the other hand we can get a pretty fancy discount on the next apartment we want to buy.
The quick buck strategy might seem very tempting when people around you make seemingly huge profits from just buying a home or flipping real estate but the back side is that they could get burned for life. The “marathon” strategy is something that will last and the best way to move towards financial Independence.
So what do you think, are you done doing sprints and ready for the marathon?