Leverage

Redeeming the four-letter D-word

I met a man who was a multi-millionaire. He was an entrepreneur and had built a nationwide business empire. He struck me as a typical salesperson — outgoing, enthusiastic, and assertive. “What is the secret to your success?” I asked. To my surprise, he responded, “I have surrounded myself with really smart people, and the person at the top of that list is my accountant.”

He told me about all of the properties he owned around the country. When he said he had loans on every single one, I was taken aback. “Doesn’t that mean you really don’t own anything?” I said rather abruptly. “Oh yes, I certainly do,” he retorted, “And I wouldn’t own anything at all if I had ignored my CPA.”

This came as a shock to me — why would a wealthy man still have loans? I was taught that debt was bad; it was the dirty, four-letter word in personal finance. The popular financial advisor, Dave Ramsey, calls debt a wrecking ball that can ruin your life.

My father provided the foundation of my knowledge about money, and he agreed with Ramsey. By the time they passed away last year, my parents had perfected the conventional formula for financial success: get a college education, earn a bread-winning income, pay off your mortgage, max out your retirement contributions, save for emergencies, live frugally and avoid credit cards. On top of this, they gave liberally to their church, paid their taxes, and pre-planned their funerals.

My father and mother made my job as the executor of their estate incredibly easy. However, their formula for financial success will not work for me or my children.

The Silent Thief

When my father started his career in 1968, his annual salary was $13,000. In today’s dollars, that would be a salary of $109,330. My mother never needed to work outside of their home, and my parents afforded their four children a middle-class lifestyle.

What do I mean by “in today’s dollars”? Inflation. As the number of dollars in circulation increases, their purchasing power decreases. Since 1968, the US dollar has lost 4.02% of value annually; as a result, everything costs 741% more today. When the government prints money to cover its deficits, it loots wealth from everyone.

How can we keep up, or better yet, get ahead, when the system is rigged against us? As it turns out, one possible answer also answers the opposite question: how do the rich get richer? They take calculated risks with debt.

As Mark Moss explains, playing the “game of money” safely — to avoid risk and to keep from losing — involves avoiding debt. But that strategy does not protect you from the silent thief of inflation or the robbery of taxes. Even if you manage to save up enough money for retirement (and half of Americans have nothing saved at all), you may not be able to leave your children an inheritance. And as a friend of mine once said, “They’ll need it.”

Good Debt

Debt, like any tool, isn’t inherently good or bad; it depends on how you use it. Most financial advisors would agree that borrowing money to buy perishables (food) or experiences (vacations) is unwise. You are left with an obligation to pay and nothing tangible to show for it, which is why such unsecured debt (such as credit cards) have higher interest rates. Lenders are facing a greater risk of your default.

Loans that are secured with collateral, such as houses or cars, have lower interest rates because in the event of nonpayment, the lender gets the property. They are not left empty-handed. This difference between secured and unsecured debt gives us a hint at how debt can be used to your advantage. The secret to building wealth using collateralized debt lies in the asset that is securing the debt. Owning assets gives you options that can multiply your wealth.

The most well-known example of this concept is owning rental property. Not only can you collect rent, but the value of the property will increase over time. As long as you are paying less in mortgage interest (and other expenses) than you are earning in rental income and property appreciation, your net worth is growing.

This is one of the ways my friend became a millionaire. He also borrowed money to invest in his core business. The business grew, and returned profits, at a higher rate than the interest he paid on the business loan — which was secured by assets he collateralized from his business (such as equipment and accounts receivable).

Using a Lever

When it comes to building wealth, owning assets free and clear is not necessarily the best strategy. The wealthiest Americans borrow against their assets to multiply their wealth, using the borrowed funds to make new investments (such as rental properties or businesses) or simply to cover their living expenses. By retaining ownership of the collateralized assets, their net worth increases as those assets grow in value.

This practice is called leveraging (or Buy-Borrow-Die) and it can be more profitable than laying away your nest egg to compound over time. Here is how it works.

Find a lender that will loan you cash in exchange for putting up your asset as collateral (similar to how a pawn shop works). If you own the asset free and clear, you may not be subject to a credit check. Find an interest rate that is less than the rate at which the asset will appreciate over the same time period.

Interest rates will vary depending on the term of the loan and the loan-to-value (LTV) ratio. The less you borrow against the value of the asset, the lower the interest rate a lender will offer. For example, the LTV on most home mortgages ranges from 80-100%. Investors who borrow against their stock portfolio may face a 50% LTV. The difference reflects the volatility of the value of the collateralized asset.

Obviously, a key consideration is your ability to repay the loan. Having other streams of income you can use to make these payments is ideal. Those who own enough assets — assets which appreciate faster than interest rates on loans — can roll over the debt. This involves taking out another loan against another asset and using it to pay off the first loan, which releases the original collateral for future use.

Leveraging is how financial assets work for you in addition to simple compounding.

Don’t Save. Buy!

This strategy sounds out of reach for most people. How can you buy assets without borrowing money, especially these assets that give you options? It sounds like a chicken-or-egg scenario, but it can be overcome with a change of mindset.

Instead of saving up your money, buy assets. Cash is not king; assets are, especially those that appreciate in value over time, generate revenues, and/or can be used as loan collateral. Such assets include not only property and businesses, as already described, but also retirement plans, whole life insurance, artwork and stocks. (This is one reason why high-income earners often prefer to be paid in stock rather than in cash.)

Today, everyone has access to an affordable golden goose: Bitcoin. Like gold or silver, Bitcoin is a commodity and can be purchased in small quantities. Better than holding gold, anyone who has held Bitcoin for a year or more has earned a median compound annual growth rate (CAGR) of 62%. If you can find a lender* who will accept Bitcoin as collateral, it checks all the boxes as a wealth-building asset you can leverage — and one that can generate cash flows instead of income.

This is another significant point. Income is taxable, but cash flows from a loan are not. In some cases, loan interest payments can also be tax-deductible. As long as you do not sell your Bitcoin, you will never owe capital gains tax, either. In contrast, owners of real estate pay property taxes and taxes on their rental income. Unless landlords pay someone else to manage their properties, they also have to work for their cash flows.

The only work involved with owning Bitcoin is learning about it.

*At the time of writing, only a few pioneering lenders offer Bitcoin-secured loans, such as Debifi.com, ByBit.com and SaltLending.com. However, Cantor Fitzgerald will soon enter this market, and more traditional institutions are likely to follow.