Let’s make one thing clear from the start. I am no math wiz, and I am not a financial planner or a finance professional in any way. While, over the years, I’ve taken the time to develop a solid foundation in finance fundamentals, I like my money management to be simple and effective. I don’t like it when money rules my life and I work to make it a low priority and happiness a high priority. With that in mind, let me take a stab at explaining one of the most powerful financial concepts in existence.[Tweet “One of the most powerful financial concepts in existence.”]
Debt is bad right? Well, yes and no. In most cases debt is a burden. Most debt comes with high interest rates that are a drain on your income. Money borrowed is often spent on things that aren’t worth what you owe. It’s really a lose-lose scenario. When you have this kind of debt, you are making yourself poor so that others can be rich. But there is one way that debt is good. In fact it’s the foundation of how banks make money, and billions in profit every year. Average people use it without even realizing it, and for lots of us, it’s the only real wealth we accumulate in our lives and we do it by mistake. It’s called leveraging and here’s how it works.
What if you could borrow a thousand dollars at 5% annually and lend it out for 10% annually? You’d make 5% profit, or $50, every year without using your own money. This is essentially what banks do. You, and millions of others, put your money into chequing and savings accounts every payday. The banks pay little or no interest on this money. Then they take it and loan it out to you in the form of home mortgages, credit card loans, and lines of credit at higher interest rates. Yes, it gets a lot more complicated than that, but essentially, this is what happens.
Many people do the same when they buy a house. We think that we make money through home ownership because the house goes up in value and we’re paying a mortgage instead of rent. There is an ongoing debate as to whether renting or owning is better, but there is one thing home ownership does, that renters don’t typically take advantage of and it makes them a ton of money.
It goes like this.
You buy a house with, say, 20% down. The house is valued at $250,000 so your personal contribution is $50,000. In 20 years the house is now worth $600,000, a return of a little under 4.5% per year. But the actual return when calculated on your $50,000 portion of the investment was more in the area of 12%. Let say you were paying 6% interest on your mortgage. You made roughly 6% by using the banks money.
So leveraging is essentially using borrowed money to invest for higher returns than the cost of borrowing.
OK, so my math is a little (meaning very) rough. I’m no Jim Cramer or Suze Orman, and I don’t feel like I’m at my peak of explanatory powers this morning, but the concept is still extremely valid, and worth understanding. Pretty much every person of great wealth exploits this concept.[Tweet “Pretty Much Every Person of Great Wealth Exploits This Concept.”]
Obviously there are finer details you need to understand. You need to work at finding cheap money to borrow. You need to find reasonably secure investments at higher rates of return. If you invest irresponsibly or impulsively you will lose your investment and still have the debt. There are two important facts to know here. The first is that leveraging works. The second is that you must continue to educate yourself in the fundamentals of finance and take personal responsibility for your financial well-being. Learn from others mistakes and from those who came before you. I have been on both the losing and winning end of the debt-for-profit game, and learned the hard way. You have the internet. Use it. Learn a little everyday. You’ll be surprised at the wealth of knowledge you accumulate over the years.
And remember, money is not happiness, but rather, it is a tool. Manage it or it will manage you.
Remember to have some fun today.