Irrespective of whether you are a businessman or an investor, you need fund to grow. Everyone starts with personal funds, but these run out sooner than later. To create wealth one has to borrow from relatives, friends, banks, financial institutions or public ones. In other words, we have to work with ‘Other People’s Money’ or OPM.
The borrowed funds have to be productively employed to earn a higher return than the interest payable. Banks do this all the time. They borrow money from us at a lower interest rate and then give out loans to businesses and property mortgages at a much higher interest rate. They pocket the difference and create millions of dollars in profit.
To create wealth, you have to think like a bank. You have to use Other People’s Money to grow. Banks borrow money from you and pay you interest on the borrowed funds. They then loan the money at a higher interest rate to business people, fund real estate and consumer goods loans. Banks make money on the difference of the interest rate they borrow and what they charge to their customers. You can grow rich by applying the same principle.
Financial Leveraging in Real Estate
To explain financial leverage, let us see how it works in real estate. Let us say you buy an investment property for $100,000 at 10% down payment. This means that you make a down payment of $10,000 and borrow $90,000 from the bank. Let us assume that the rent from the property covers the interest and expenses on the property. If the value of that property increases by 7% over the year then the property would be worth $107,000. This would mean that your investment of $10,000 has earned a whopping return of $7000 or 70% yield.
This happens because you get to leverage not only on your investment of $10,000 but also on the borrowed amount of $90,000. There are sophisticated property investors who buy property with ‘no money down’ or very little of their own money i.e. they work on 100% borrowed funds. In this case, the return on investment will be infinity.
Good Debt and Bad Debt
Borrowing money and creating debt is good if the funds are utilized intelligently to create wealth through business and investment. The profits need to exceed the cost of borrowing. A debt created for consumption purposes: for buying luxury items such as cars, television, etc. is bad debt. Such debts take money out of our pockets and have to be treated with great caution.
Borrowing money is great if you buy investments that make you rich. It is bad if the borrowed funds are used for purchasing consumption goods like cars, boats, TVs, holidays etc that depreciate in value the day you purchase them.
Good debts make us rich. Poor debts make us go broke. The power of leverage in finance, when applied correctly, can make us grow rich exponentially.