Debt: it’s often seen as a negative word that implies financial trouble or stress. Many people try to avoid debt as much as possible, thinking that it will only drag them down. However, not all debt is bad. In fact, some forms of debt can help you increase your wealth over time.
What is Leveraged Return?
To understand how debt can be beneficial, we must first understand the concept of leveraged return. Archimedes discovered the principle of leverage in the 3rd century BC. The idea was simple yet revolutionary: a small force applied at one end of a lever can move a larger load at the other, with the fulcrum acting as the pivot point.
This same principle is also applied to finance when you use a small amount of your own money to control something that’s much more valuable, thereby multiplying your returns (or losses). This is known as ‘leveraged return’. Like using a longer lever to lift a heavier object with the same effort, leverage in finance allows you to achieve greater returns with the same initial investment.
Mortgaged Property: A Leverage Tool
One of the most common ways to use leverage is through real estate. When you buy a property with a mortgage, you only need to pay a fraction of the property’s total value as a deposit. The rest is borrowed from a lender. Now, any increase in the value of that property is not just a return on your deposit; it’s a return on the property’s full value.
Example:
Suppose you buy a £200,000 home with a 20% deposit (£40,000) and an 80% mortgage (£160,000). After one year, let’s say the property appreciates by 5%, raising its value to £210,000. That £10,000 increase is not just a 5% return on your property’s price; it’s actually a 25% return on your initial £40,000 investment, thanks to leverage.
Stock Market vs Mortgaged Property
If you invested that same £40,000 in stocks and achieved a similar 5% return, you would have earned only £2,000. Although the stock market can offer good returns and diversification, it usually doesn’t provide as much leverage as real estate. However, there are other ways to use leverage in the stock market, such as buying stocks on margin or using options or futures contracts.
Leverage: A Double-Edged Sword
Of course, leverage is not without risks. Just as it can magnify your returns, it can also magnify your losses. If the value of your leveraged asset goes down instead of up, you will lose more than your initial investment. For example, if the £200,000 home in the previous example depreciates by 5%, its value will drop to £190,000. That £10,000 decrease is not just a 5% loss on your home value; it’s actually a 25% loss on your initial £40,000 investment.
Moreover, leverage involves borrowing money, which means paying interest and fees. These costs can eat into your returns and increase your debt burden. If you fail to repay your debt on time, you may face penalties or even lose your property to repossession or liquidation.
Therefore, leverage should be used with caution and prudence. You should only use leverage for assets that have a high potential for appreciation and a low risk of depreciation. You should also have a clear exit strategy and a contingency plan in case things go wrong.
Leverage: A Powerful Tool for Wealth Creation
When used wisely and responsibly, leverage can be a powerful tool for wealth creation. It can help you acquire valuable assets with a small amount of money, and generate higher returns than you could otherwise achieve.
However, leverage is not a magic bullet. It requires careful planning, research, and discipline. It also involves taking on more risk and debt, which can backfire if the market conditions change or if you overextend yourself. Therefore, you should always weigh the pros and cons of leverage before using it, and seek professional advice if needed.
Leverage is not always a bad thing; it can be a good thing if you know how to use it properly.
How Fuchee Can Help
With Fuchee, assess the affordability of debt before committing. Continuously check your financial health, understand the long-term impact of leverage on net wealth, and utilise our advanced tools to strategise investments as well as keeping this all balanced with your goals and everyday needs. Make informed decisions and ensure you and your finances thrive.