Home > Uncategorized > Good And Bad Leverage

Good And Bad Leverage

December 30, 2011 Leave a comment Go to comments

The last line in my previous post touches on something I come back to now and then to plan my finances. I first heard of this idea from Robert Kiyosaki, who wrote something like “whenever I want a fancy car, instead of just going out and buying it I buy a property that will pay for it”. As usual it’s not quite that easy but there is an element of truth.

A lot of writing about personal finances is about moving from the lowest level of stability (borrowing to buy things) to the middle level (saving so you don’t have to borrow). This lowers your total spending since you pay less interest. But when you do this you still need to earn the money to pay for what you want to buy. Not that there’s anything wrong with this but I always like to do a little better 🙂

When you take this idea further you could call these the 3 levels of leverage:

  1. Borrowing to pay for things: this is leveraging other people’s capital and comes at a price (more time working to pay for your expenses)
  2. Paying from your savings/earnings: this is the minimum financial leverage, relying on your work to pay for things
  3. Paying for things with investment (“passive”) income: this is using reverse leverage, putting your capital to work to minimize the work you need to do

Of course the highest level is what people think of as retirement. Sometimes they plan to skip the middle level entirely. I prefer to stay out of the lowest level as much as possible though. In reality we get a mix of these. It’s hard to live completely in the middle if you’re doing things like buying a house. And with my businesses I have opportunities to do things that are in between working and passive income. Staying out of the lowest level is an accomplishment but it’s not the end. My goal is to get as close to the third level as soon as possible.

Even being able to pay for minimal survival expenses from investment income and working for the extras would be a big step up. As mentioned in the last post, one of the simplest ways you can do this is to be invested longer. If you put off spending and invest more instead, you can spend later while your investments are growing. Delay an expense long enough and the investment income can take over paying for it.

This takes a bit of time though. I recently calculated that if you invest as much as you spend it could take 10-15 years for the investments to reliably pay for the spending. Many expenses can’t be delayed that long. Trying to reduce the time for your investments to cover your spending is hard since the power of being invested for a long time is so strong that there are few alternatives. The best thing you can do is maximize the time you give yourself, in any way you can. And if you have an expense that’s more than 10 years away it can be much cheaper to pay for it through investments rather than just saving up the full price in cash.

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