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Leverage, Leverage, Leverage! April 14, 2008

Posted by shaferfinancial in Uncategorized.
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So, you want to create wealth.  Then you need to understand the importance of leverage.  Now leverage has gotten a bad name to average investors because it creates risk of loss.  I think people sometimes misunderstand what leverage is all about.  When thinking about leverage, think about what a lever is.  A lever is a tool that allows you to move/lift more weight given an equal amount of force.  It gives you what is called “mechanical advantage.”  When we look at wealth creation, we see that leverage is a requirement for producing wealth.

There are three types of leverage.  First is financial leverage.  Using real estate as an example, financial leverage is about controlling a large asset with a smaller amount of money.  When you buy real estate with 20% down, you control the whole asset.  So if you buy a home for $250,000 and put down $50,000, financing the rest, you benefit from the entire $250,000 home.  If over the next five years it becomes a $300,000 home and you sell it, then you have made $50,000 by investing $50,000 plus the cost of financing and ownership.  In other words, even though your home has only gained 20% in value, since your initial investment was only $50,000 your actual rate of return was almost 100% (you still need to account for your financing costs and any other costs incurred).  Financial leverage allows you to use “financial advantage” to control a large asset with a substantially smaller cost.

The next type of leverage is labor leverage.  This is enjoyed by business owners.  Every employee hired by a business owner should produce an excess to their cost (or why hire them).  Say a business owner requires each of his employees to produce an excess $10,000 to the bottom line of his business.  The owner can leverage this labor as high as he can.  When adding an employee doesn’t give the owner a net benefit, then the hiring stops.  So if he is able to hire 25 folks that meet his $10,000 added value requirement he is able to produce $250,000 in profit by labor leverage.

Finally, is value leverage.  A land developer is looking to buy land to develop.  This developer can leverage the value of the undeveloped land when he adds to the value by visioning an end use for this vacant land.  Now that end use might be a shopping center, or single family homes, or some other commercial use, but what the developer is doing is leveraging the end use value of the land compared to the current value of the land.  The more successful the developer is in this leverage, the more value added he creates, the more profit is obtained.

In order to create real wealth, not just get lucky with speculation, you must use one, two or all three of these leveraging startegies.  However, be warned that if you are only using financial leverage for speculating on real estate, stocks, or any other investment, then you have multiplied your risk.  That is not to say that, speculating is bad, but only pointing out that financial leverage needs to be understood fully in the context of the underlying environment.    

Why do the average Americans have so much more value in their homes, than their investments?  Because they use leverage to purchase their homes, but don’t leverage their mutual funds or other investments.  The truth is that most folks go through their lives only using leverage to purchase their homes, and are unable to build wealth because of this lack of leverage.  And people who have brought wealth to their lives all use leverage to accomplish it.

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Comments»

1. MyPoolsideOffice.com - May 25, 2010

Great Post!!!


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