Leveraging: how the wealthy get wealthy, how the rich get rich!

Apr 29, 2018

This is how the wealthy get wealthy, how the rich get rich!

We’re discussing the two-tiered economy and leveraging – taking something that you don’t have, investing it, and growing that over time. It’s one of the tricks behind how companies and individuals can amass such great fortunes leveraging to generate additional returns. But, the higher the reward, the higher the risk.

You can do it to! Only catch is you have to borrow at a higher rate than the Banks, so you better make it worthwhile!

What the process is, how you can make it work to your advantage, and how to not mess it up.

Debt – Leverage & Borrowing money to invest

1. Agree or not – Is $100k worth more than $50k? – It’s about the nominal increase in value
2. Looking at returns as a percentage of the investment value – the greater investment value, the greater dollar value or nominal return at same percentage rate.
   1. We are locked into same percentages for ASX – however different amounts invested will earn different nominal returns in the same environment.
   2. The rich ARE getting richer – due to having larger amounts invested into the same stuff as everyone else, earning the same percentage return.
3. Does debt go up with inflation in value?
   1. No, you pay interest instead
   2. This is why you borrow to invest in something that grows, rather than just keep it in your bank account.
   3. Time goes on, your investment increases, debt doesn’t.

1. Borrowing funds to invest is a strategy known as leveraging.
   1. Good Debt – not because you can claim a deduction for the interest payments but that you’re investing in something that increases in value.  
   2. Bad debt – you’re simply paying interest to borrow money and the value isn’t expected to increase
2. The principle of increasing long term capital growth rather than investing in something for an income.

How it works

1. Options
   1. Home equity – Drawing on equity to buy shares, or managed funds
   2. Debt recycling - borrowing more each year and using the income from investments to pay down bad debt

Leveraging works better for growth and not cash flow.

Having it is neutral position to slightly positive is thing that max leverage.

1. Loan to value ratio (LVR) is the loan amount divided by the value of your property
2. Paying back your loan principal reduces your LVR = Lower multiple of growth, but lower repayments for cashflow.
3. Increase loan with value = Increasing multiple of growth, but higher repayments.

How to start

Example: Property – Initial purchase and building equity

1. Utilise equity of $100,000 to purchase a property for $500,000. This gives you a LVR of 80%.
2. If the property value increase by 8%, you have an 8% return (8% of $500,000 = $40,000)
3. Essentially you have put $100,000 in to get $40,000 back, or a 40% return.
4. Interest payments – Have to repay interest on the borrowings.
5. The borrowing of funds against a property for investment purposes. The process involves having the home revalued.

Is it worth it to leverage?

• Hurdle rate - the minimum rate that you need to earn when investing.
  When borrowing to invest, your hurdle rate will be the cost of borrowing the funds (interest payments).

Downsizing risks - Where it goes wrong

1. Wrong investments, no diversification. Shares or managed funds?
2. No liquidity, or not reducing investment time risk – Dollar Cost Averaging (DCA)
3. Disposable cash flows low – job security
4. Panic selling or being forced to sell
5. Buffer account – lower LVR or surplus cash

Example:
Your property, valued at $500,000 has grown to $700,000, your mortgage is $450,000

1. If the value is $700,000 and the current loan is $450,000
2. The bank will currently lend up to 80% of the value – an 80% LVR
3. This means that you can borrow more against the property, up to 80%, or $560,00. That’s an extra $110,000 you’re able to borrow against your property.
4. Initially $30,000 is invested with monthly investments of $3,000 established. 

 

So, in summary;

• Leverage for growth
• This is a LONG-TERM strategy
• Risks can be worth it if done correctly

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Remember – this is General Information only!

This podcast includes general information only and does not take into account your personalised situation, including:

• Investment objectives
• Financial situation
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