We’ve talked about total return, the combination of income and capital growth that makes an investment a powerful wealth-building tool. One of the golden rules of building wealth is to have many strings to your bow, of which those are just two.
As well as income and capital growth, leverage is another useful factor in building wealth. With leverage, you borrow money to capitalise on an opportunity in a bigger way than if you just had your own money to use.
Hang on, Pete. You just said ‘borrow money’? Doesn’t that mean debt? Yes, it does, but it’s good debt as long as you’re borrowing at a low interest rate and buying an appreciating asset.
Here’s an example. You want to buy a house for £200,000, but you only have £50,000 available. You take out a mortgage – the leverage for £150,000, add it to your £50,000 and buy the house.
Over time, the value of the house rises to £300,000, so you sell it. You pay back the mortgage of £150,000 and you’re left with £150,000 in your pocket. You have turned £50,000 into £150,000 by borrowing that mortgage money. It enabled you to buy a bigger asset which has grown more quickly.
That example conveniently forgets to mention the interest payments on the mortgage, the rent which might help you pay those, plus taxes, stamp duty and all kinds of other things, but this is the principle we’re talking about!
Leverage increases risk – that’s crucial to know. If you borrow money to buy a house and rather than grow in value, it turns out that a massive flyover is built right next to it and the value plummets – you still owe the money, the asset is worth a lot less than you paid for it and you’re very much OUT of pocket. Leverage essentially magnifies both gains and losses – it amplifies the risk.
Another useful string to the bow is opportunity money; that is, money you have to one side that you can use if an opportunity presents itself. Occasionally life throws things in your path that you might want to take advantage of, but you need to be able to do that by having the capacity to take advantage. In the case of investing, that might mean having something of a war chest available to buy into an investment opportunity. Care is needed here, but again, it’s the principle that stands.
And let’s not forget one of the greatest forces for wealth-building that exists – compound returns. This is the process where your money makes money, by one of the means we’ve just covered, income or capital return. And then that money makes more money, and then that money makes more money until it becomes like a snowball, gathering pace and mass.
Compounding can take a while too spool up, which is why investing is best done over the long term, but it is immensely powerful and can lead to the point where your investments take on a life of their own, working for you in an increasingly powerful way.
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