Monday, June 6th, 2016
One of the most powerful and fastest ways to build wealth is to use the principle of leverage. Leverage simply means to borrow money to invest in the expectation that the net returns from the investment will be greater than the interest payable on the loan. Leverage can be thought of as using other people’s money as well as you own to increase your investing power.
A common way of using leverage is to purchase an investment property. Here is how it works. You have $80,000 to invest. You use the $80,000 as a deposit on a house worth $400,000 and borrow the remaining $320,000 at an interest rate of, say 4%. Let’s say your investment property produces a gross rental income of $20,000 in the first year (5% of the value of the property). Interest is $12,800 and you have other expenses such as rates and insurance which use up the remainder of your rental income. However, the property grows in value by 10% ($40,000). You have invested $80,000 for a return of $40,000; that’s a 50% return on the money invested!
The reason this works is that the return you achieve on your investment asset is higher than the cost of borrowing. However, leverage should be used with caution. While it is capable of magnifying your profits, it can also magnify your losses. It is very important to establish from the outset that your intended investment will make a profit. Going back to our property example, if the rental income is not sufficient to cover the interest and other expenses and property falls in value, you will make a huge loss.
Leveraging offers potentially high returns but with high risk. Whether it is an appropriate strategy for you depends on your risk tolerance and your overall financial situation.
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