Using Debt to Earn More
How can taking out more debt actually help me to make more money, you ask? Seems kind of counterintuitive doesn’t it? Well, it doesn’t need to be if you’re smart about how you use this leverage. Of course, this doesn’t mean to take out debt and spend it on frivolous expenditures. Rather, put it to work for you.
So how does leverage increase my returns and help me to earn more?
The general idea is that you stand to earn more money if the interest rate you’re paying is less than the rate of return you’re earning. The benefits of leverage are seen through the difference between the two rates, which represents your differential rate of return. Think about it this way. Someone loans you $1,000 with an interest of $100, but you are able to use this $1,000 to earn $200 in profits. You can then take your $1,200 and pay off the $1,100, leaving you with an additional $100 that you may otherwise have not been able to earn without the initial $1,000 loan.
This is known as leverage. It can be extremely beneficial for amplifying your returns, so long as you can pay the interest on time. After all, who wouldn’t want to earn more than what they’re making now?
Some caveats associated with the use of leverage.
Of course, if the successful use of leverage was so easy, everyone would be doing it for every aspect of life. Unfortunately, this is not the case.
With every upside potential comes downside potential. You must exercise particular caution when using leverage as this tool amplifies losses as well as gains. Just as it can help you to get ahead much quicker in your returns, it also makes the impact of losses much more significant.
Leverage requires a degree of confidence and comfort. Since you are essentially playing with someone else’s money, you must be very confident in your abilities, or at least have considered all possible outcomes. Similar to the case of amplified losses, not being able to meet the debt obligations of leverage can lead you into other tough situations.
So where can the logic of using leverage be applied?
If you’re wondering where leverage is best used and have guessed that it occurs in almost any investment scenario, then you’re right! This could involve any of the following, as well as many more:
Stock investing. This is called trading on the margin, since you earn the difference between the rate of return and the interest rate owed. However, stock investing should be left to those who are very skilled and educated about trading in the stock market.
Any business-related investment. If you are starting your own business and have forecasted a rate of return that will exceed the interest rate of debt, then it would be a wise business and financial decision to take advantage of it. Companies often use this for quicker expansion and growth opportunities, rather than relying on their own funds. Of course, this is assuming that you will have the cash flow to meet interest payments as they come due.
Real estate investment or your personal home. Just as with any other investment, your potential gains could be magnified. Read our article about using leverage in real estate investment for all the details.
One final note about leverage.
Leverage typically works best when you have some original lump sum of money. However, this amount does not need to be as much as you seek to obtain through debt options. In fact, you typically always need some money or other collateral assets to even get financing in the first place. Lenders need to see that you have some skin in the game too. Often, the more cash you have, the better the rates you will be offered. So why wait? Use leverage to start earning more today.
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