LEVERAGE - What is it?

Let the blogging begin again.  With winter coming on, it looks like a good time to resume posting.  This morning I was thinking random thoughts - a regular occurrence for moi.  And it always leads to interesting random connections in my mind.  This morning my thoughts veered to leverage.  What exactly is leverage?

If you look up the dictionary definition in Websters, leverage is 1) the action of a lever or the mechanical advantage gained by it, 2) effectiveness, power.  Okay, not very helpful when you consider all the uses of leverage in our society, but it’s a beginning.

Checking a thesaurus (I used those from Princeton University and Collins Thesaurus) you find synonyms such as purchase, leveraging, influence, authority, pull, force, hold, strength, grip, grasp, weight, rank, clout, and purchasing power.  Leverage can provide an advantage or bargaining chip.

LEVERAGE - How do we use it?

If you think about it, you use leverage all the time.  Have you ever opened a jar using a rubber lid opener?  Leverage.  Used ski poles to push off down the hill?  Leverage.  Have you purchased a home by using a mortgage?  Leverage.  Purchased anything on credit?  Leverage.  Put some muscle into using a long handled spade to turn over your garden?  Leverage.  Called an old colleague about possible job connections?  Leverage.  Asked a friend for an introduction to someone they know who is knowledgeable in an area you want to pursue further?  Leverage.  I think you get the idea.

LEVERAGE AND WEALTH

We use leverage constantly in our daily lives.  But the leverage I want to address is financial leverage.  Financial leverage can be good or very very bad.  The Great Depression was leverage gone very wrong.  The economic meltdown of 2008 was leverage gone very wrong.  The rise of the US stock market through the 1980s and 1990s was leverage that helped a lot of people amass wealth.  And the rise of the housing market until the latter part of 2007 was also leverage working its magic for homeowners and real estate investors.  Great stories of riches gained were common during these periods.  The technology industry was a great user of leverage in the 1990s.  That is until the bust came in 2000.

If you think about it, our economy is built on leverage.  How many people do you know (and maybe see in the mirror in the morning) who have used credit cards to leverage their income into a buying machine?  How many people used disastrous variable rate mortgages to leverage their assets and income into a home that they couldn’t otherwise afford?  How many people used the equity in their home as an ATM?  We Americans thought the party would never end.  At least those who hadn’t been through the Great Depression thought so.  But the party did end because the use of leverage was out of control.  I could write a post longer than you are interested in reading on all the causes and influences that created the mess we’re in now, but I’m sure you have your own ideas about that.

USING LEVERAGE IN THE FUTURE

So do we just stop using leverage to improve our financial condition?  For most people, that’s not possible when you consider the cost of real estate or vehicles and other big ticket items or the cost of building a business.  Some leverage is needed to allow people to grow into their future income and take advantage (leverage) of the positive factors that are available right now.  But to use leverage effectively, you have to have a good foundation to stand on.  Pulling on a lever in quicksand doesn’t work well at all.  That foundation is what has been lost in our society as envy grew and people felt they were “entitled” to what their neighbor had too.  Maybe the neighbor is in debt up to his eyeballs and about the declare bankruptcy.  Someone looking in over the fence doesn’t know that.  Or maybe the neighbor is the millionaire next door who lived a frugal life for decades to be able to live very comfortably later in life.  Delayed gratification.  Something we all need to grab onto to build that great foundation.

WHAT NOW? 

Things happen for a reason.  If the economy hadn’t failed in 2008, it may instead have failed in 2010 or 2012.  It was going to happen because of the leverage being used in ways it never should have been.  The entire economy was caught up in using financial leverage to have it all now.  But something good happened along the way.  People took it as a wake up call.  The savings rate in the US has increased dramatically.  With no equity left, homes were no longer an option for spending.  People are just trying to hang onto their homes in many cases.  But the frugal people still DO have equity.  Some own their homes outright.  Their frustration is that we are all paying for the foolishness of those who wanted it all now without any thought of how they were using leverage.  We will get through this and those who were wise enough to spend less than they make and have money to invest will be the ones who get to take advantage of the opportunities for wealth that the current market presents.  Our country is full of opportunities if you look for them, but it takes hard work, a willingness to sacrifice rewards in the present for those in the future, and having goals for the future so you are already looking in the right place when opportunities arise.  It’s not magic; it’s being intentional.

READ!

If you want to find those opportunities, you have to educate yourself in areas that will help you create a contented future.  A future that is free of financial fear and is one of hope and satisfaction is possible.  Look around and find a path that fulfills your desire to have a good life.  People move themselves out of dire situations all the time when they have the will to make their life different and aren’t willing to let obstacles get in their way.  Desire is a powerful motivator.  Combined with common sense and a frugal outlook, you can move mountains.  Reading books that will improve your skills and listening to and reading about people who have “made it” and share their stories can give you ideas on what your path should be.  Leverage your mind to increase your knowledge and a whole new world will open up.  Leverage can be a very good thing when we use it to improve our lives now for a lifetime of happiness later.

It’s a new month and about to be a new year.  America is still the land of opportunity.  We have over 200 years of leverage working for us.  It’s not over yet!

Are you familiar with leverage?  Have you used leverage?  If you’ve purchased a home, chances are you have.  When you made that purchase did you make a down payment of 3, 5, 10% or more?  How long ago did you purchase your real estate?  Depending on that answer you have either leveraged up or down.  It’s also dependent on where you live.  Florida?  California?  Phoenix?  Las Vegas?  Michigan?  If you bought in one of those places between 2004 and 2007, you most likely leveraged down.  If you didn’t make a down payment, you may now be in foreclosure or on your way unless you locked in a fixed rate that you could afford.  If you used creative financing, you used another type of leverage and the combination can be deadly to your finances.

Leverage according to Daniel Webster is “1) the action of a lever or the mechanical advantage gained by it, 2) effectiveness, power”.  A Lever is “an inducing or compelling force”.  I like that word, compelling.  The effect of leverage is compelling.  It creates power.  It creates the power to gain or lose.  Leverage is what caused the Great Depression.  Leverage is what you use when you buy a home using a down payment or no down payment and financing.  It is neither good or bad by itself.  It all depends on the context in which it is used.

Here’s an example.  You are buying a $250,000 home and buy it with a conventional loan in the current market.  You provide a down payment of 20% or $50,000.  Now we know it isn’t going to appreciate anytime soon, but when it does, we’ll assume the average appreciation rate for the next 7 years (the average real estate ownership period) is 5% per year.  That means that in 2016 your property is now worth $351,775.  You have a gain in simple terms of $101,775.  When you divide that number by your down payment your money is now worth a little over triple what you invested.  You have made a 204% return or an average of 29.14% per year on your cash investment.  Your investment was not the purchase price of the home, it was the amount you invested as a down payment.  That’s leverage.  Is that better than a CD?  Better than the average return of stocks over the past 80 years?  Not bad.  And you get to live in the house, use it, make it your own, not have a landlord, and get tax breaks to boot.

What if you bought that same home in 2006 for $350,000 and not soon after it nosedived and when you needed to sell in 2008 you could only get $250,000.  The $50,000 you risked now is a loss of $100,000 or a 200% loss.  Again, you used leverage, but this time it didn’t benefit you.  That is why real estate, like stocks, should be considered a long term investment.  That’s why it is important to buy wisely and make sure the mortgage you get is one you can handle under most circumstances.  That’s why it is important to have additional reserves to get you through the hard times before purchasing real estate.  We just don’t know when those hard times will hit.  We don’t know when the balloon will pop or when the balloon will rise again.  Buying real estate is a lifestyle and investment choice that has to be carefully considered.  Sometimes circumstances are out of our control, but most of the time you will be able to control your circumstances by the choices you make before buying.  It does pay to be prepared.  Leverage is why the rich get richer.  That’s why paying interest on credit cards is a bad idea.  You are leveraging your debt to the benefit of the credit card company.  This market is making people think about frugality differently.  Being frugal is smart and allows you to leverage the money you have to your benefit.  Compounding is the eighth wonder of the world.  Be a winner!

So consider your current situation and how you might use leverage.  Is it a wise choice for you?  Check out the Recommended Reading List Page to find resources that will help you learn when it is and how to control more of your own circumstances.