Getting the most out of your MONEY - Lesson 4

The principal of leverage

Before we get going I wanted to give you another tip on advisors which I have found keeps me out of trouble a lot.

It’s simple but for what it’s worth ; If you don’t understand the advice, don’t take it or implement it.

Now today we are looking at leverage. Remember yesterday we were looking at accumulating capital and making sure that it was the right type. So what’s the type which normally produces expenses? - Personal Capital
And what’s the type which normally produces income? - Investment Capital

The word debt sends shivers down many peoples spines because they, or someone they know, has had a bad experience with debt. But many times people have got into trouble with debt because they have not understood its nature or real purpose. They kind of know it helps them buy large items such as houses but are never quite sure how the money works. All it seems to them is that there is another big bill to pay every month.

Let me start with the basics around leverage because if you can grasp this you will be able to accumulate your Investment Capital much quicker without having to take on unnecessary risk and the stress which comes with it.

Leverage is defined in the Merriam-Webster Dictionary as:
The action of a lever or the mechanical advantage gained by it.
In financial terms the lever is the use of debt to supplement equity.
For example if you have $100 of equity and want to buy capital of $200 it is impossible. However if you use your equity ($100) and debt ($100) you can purchase the capital of $200.
Leverage is therefore known in simple terms as how much you lever up your equity with debt to allow you to make bigger investments in capital.

So how would this look on The Financial Fence®?

The posts of The Financial Fence® are where capital is accumulated. The posts are also made up of two parts which balance against each other. It is a simple equation which is
Total Capital (Personal Capital and Investment Capital)
EQUALS Funding (Debt and Equity)

So accumulating capital requires it to be funded by either debt or equity. Most people don’t have enough equity to buy the capital they want and therefore use debt to make up the difference.
Understanding leverage allows you to use different ways to fund your capital and make faster progress in building capital.
Tomorrow we will look at the risk of using debt in accumulating capital more quickly.

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