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The Bank of You University Podcast
Episode 007 – The 12 Principles of Money, Principle #4 – Leverage
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This episode of The Bank of You University Podcast series takes another look at our unique and proprietary approach to financial planning. It answers the questions:
- What is Leverage and why is everyone do down on it?
- How Leverage can make a mediocre investment shine
- How can Leverage amplify everything?
- If a little Leverage is good, then why isn’t a lot of Leverage GREAT?
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Show Notes:
Definition: Leverage Amplifies Everything
In the world of money, leverage means DEBT!
Debt, the nemesis of Dave Ramsey and Suze Orman
Without leverage, our financial systems would simply not function
DEBT Is Not Another Four Letter Word!
Dave Ramsey – Pay off all of your debts, including your mortgage before you start to save for your retirement
Not inherently a bad thing
Leverage amplifies gains
Multiplies our losses
The 4th Principle of Money we simply state that, “Leverage Amplifies Everything.”
Example of an Investment with No Leverage
Initial Cash Investment = $100,000
Rate of Return = 10%
Return on Investment = $10,000
You would have earned $10,000.
Example of an Investment with Leverage
Initial Cash Investment = $10,000
Borrow = $90,000
Cost of loan 6%
Total Investment = $10,000 + $90,000 = $100,000
Rate of Return = 10%
Return on Investment = $10,000
Invest $100,000
Only going to invest $10,000 of our own money
$90,000 will come from other people (O.P.M. – Other People’s Money)
Borrow from them at a cost of 6%
$100,000 to invest at 10% per year
End of the year earned $10,000
Need to deduct the cost of borrowing the $90,000 from our $10,000 of earnings
6% interest the cost of borrowing $90,000 would be $5,400
As a result:
$10,000 – $5,400 = $4,600 in Net Profits
Bad deal?
How much of your money did you actually invest?
$10,000
Borrowed the other $90,000
Investment formula looks like this:
$4,600/$10,000 = 46% Rate of Return
Your profit exploded!
This is the power of Principle #4 – The Principle of Leverage.
Increased the net rate of return by a whopping 460%
If you were to follow that logic one might conclude that if a little leverage is good, then a lot of leverage would be……..GREAT!
NO INVESTMENT is absolutely risk-free
Example Losing 1% with Leverage
Initial Cash Investment = $10,000
Borrow = $90,000
Cost of loan 6%
Total Investment = $100,000
Loss of Return 1% = $1,000
Net Investment = $99,000
Rate of Return = 10%
Return on Investment = $9,900
Cost of borrowing = $5,400
Net Returns $9,900 – $5,400 – $1,000 (Loss to principle) = $3,500 in net profits
Now our returns look like this:
$3,500/$10,000 = 35% Rate of Return
1% loss
Rate of return to decrease by more than 20%
Initial Cash Investment = $10,000
Borrow = $90,000
Cost of loan 6%
Total Investment = $100,000
Loss of Return 6% = $6,000
Net Investment = $94,000
Rate of Return = 10%
Return on Investment = $9,400
Cost of borrowing = $5,400
Net Returns $9,400 – $5,400 – $6,000 (Loss to principle) = ($2,000) net LOSS
Total Investment = $10,000 + $2,000 = $8,000
Now our returns look like this:
($2,000)/$10,000 = 20% Loss
Initial Cash Investment = $10,000
Net Investment After Loss = $8,000
Difference Needed to Break-Even $10,000 – $8,000 = $2,000
$2,000/$8,000 = 25%
6% loss of principle you would need to earn 25% on your money just to earn back the money you lost.
That is a big problem, but it gets worse.
You would likely need to invest in a riskier investment, one that would pay a higher rate of return. Higher rate of return comes a higher risk of loss
But wait…there’s more!
Initial Cash Investment = $10,000
Net Investment After Loss = $8,000
Difference Needed to Break-Even $10,000 – $8,000 = $2,000
Cost of Borrowing = $5,400
Total Return Needed to Break Even = $2,000 + $5,400 = $7,400
$7,400/$7,900 = 93.67% Just to Break-Even
Why not borrow enough money so that the same investment with the same rate of return would earn enough money to bail you out. Brilliant! !
Brilliant unless, or until, you experience another loss of course.
Leverage is another financial tool
Used unwisely, excessively or foolishly it can be an absolute disaster.
Should you consider using leverage to help you to achieve your financial goals?
Absolutely yes!
In fact it is almost impossible for you to achieve your financial goals without using Leverage
- Use it wisely
- Use it appropriately
- Understand and the risks
- Have a realistic plan to recover from any losses you would experience if/when they do occur.
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