The Fast Track to Your Financial Freedom (Part 1) - Leveraging Your Money

Think about the money you deposit in a bank. The bank happily pays you interest from the day you deposit the money. And the longer you agree to leave it there, the higher the interest rate the bank is willing to pay. Did you every wonder why?

The answer lies in what the bank does with your money after you deposit it. You may say that the answer is very simple; they lend the money back out at a higher rate. That answer would be accurate but not complete. In fact, they do not just lend your money out. They effectively lend out up to TEN TIMES your deposit. They have the advantage of LEVERAGE. The reason for this is that the Federal Reserve Bank only requires banks to keep a portion of their loans in reserve; currently 10%. As the bank makes a loan, the loaned money is deposited back into the banking system and a new loan is made. This happens repeatedly until ten times the amount of the original deposit is loaned.

So the bank is very happy to pay the 2% interest on your loan when they will in effect be able to lend out ten times the amount at, say 6%. So on your $1,000 deposit, they pay you $20 and they earn $600. Not a bad return, considering they are using YOUR MONEY. Of course, the more the bank receives in deposits and the more loans it can make, the greater its returns and profit.

Now, there's absolutely nothing wrong or evil with the way banks make money. In fact, it is essential to an expanding economy for the banks to create money in the way they do. What most of us don't realize is that we can use the same principles to expand our own money supply. We simply have to apply these principles to our own investing.

What the bank does is use leverage, i.e., other people's money and velocity, continually moving that money, to continually expand their profit base. Individuals have the same opportunities but many of don't realize it. A simple example of compound interest can illustrate how individuals can use the bank's money to increase their own wealth and cash flow:

Suppose, for example, that an individual has $20,000 to invest. Most investment advisors would tell that individual to put the money in a mutual fund to receive the "high" returns of the stock market. So, let's suppose the investor follows that advice and invests the $20,000 in a mutual fund. Let's say also that the mutual fund does well and returns a 10% return every year for seven years and that all income from the mutual fund is reinvested at the same 10% rate.

At the end of seven years, the investor's $20,000 will have grown to $39,000, or almost double the original investment. Most investment advisors (and most investors) would be very happy with this return. In fact, it would be most unusual to do this well over a seven-year period given the stock market's fluctuations. This result is actually a demonstration of compound interest.

Now let's look at what happens if the investor instead uses leverage to increase the return on that $20,000 investment. For simplicity, let's use real estate for our example. We could use other investment vehicles, such as business activities or stock options, but we are all familiar with how leverage works in real estate.

Instead of investing the $20,000 in a mutual fund, let's suppose instead that the individual invested in a single-family home. Let's suppose the investor puts down 10% on a $200,000 house (including closing costs). Let's further suppose that the investor then rents the house for an amount equal to the monthly mortgage and maintenance expenses of the house. Then, let's say that the house appreciates at an annual rate of 5%.

At the end of seven years, the house will be worth $281,000. The investor's $20,000 will have grown to $101,000, or roughly 2.5 times the return from a good mutual fund. It's probably safe to say that this is a considerably better result than the mutual fund. This result occurs because of the principle of LEVERAGE.

The investor in this case received not only the 5% appreciation on the original $20,000 investment, but also received 5% on the bank's loan of $180,000. Of course, many real estate markets are currently appreciating at a much higher rate than 5%, so this return could be unrealistically low. But the average appreciation in real estate over the past several decades has been around 7%, so 5% is a nice, CONSERVATIVE, example.

You may now be thinking that this whole idea of leverage is great and earning $81,000 on a $20,000 investment over seven years would be terrific. The problem with this is "IT'S STILL TOO SLOW." We can still do much better. Besides leverage, we need to add the principle of VELOCITY. For more on Velocity, please see my article: "The Fast Track to Your Financial Freedom (Part 2) - Adding Velocity to Your Investments".

Warmest Regards,

Tom