Leverage: The Secret of Making Big Money

This is a guest post from ‘frugal‘ and first published at 1stMillionAt33. If you like what you see here, please consider subscribing to his RSS feed.

Have you wondered how some people get so incredibly rich? There’ss a saying: “You need money to make more money.” If you hear that from a poor person, it may sound like sour-grapes. But underlying it, there is probably a grain of truth, not well-understood by the person who says it, but a good observation nevertheless.

What happens usually is that you need money or an asset to borrow a lot more money, which you can use to make even more money. It’s a game of leverage. The money-making potential is always proportional to the total amount of money involved. Whether it’s borrowed or not, it doesn’t matter. So when a business owner is successful in his or her venture, he or she will be handsomely rewarded. But if he or she fails, the leverage works in reverse and may lead to substantial loss or even bankruptcy, depending on the company structure and amount of risk and leverage that is undertaken.

In fact, leverage comes in many forms, and in each case, you can see its multiplicative power.

1. Leverage of employee’s time: As long as each employee can bring in more money than his or her wage, then the money left or the net profit goes into the employer’s pocket. The employer or the business owner is leveraging an employee’s time to make money. Multiplying by more employees is multiplying the profits.

2. Leverage of the machinery: As an example, for an internet retail business, it leverages computer equipment to take purchase orders. Equipment has a fixed cost. As long as the equipment brings in more money before its utility is fully depreciated, then it’s good business. Multiplying by more equipment multiplies the profits.

3. Leverage of copies or copyright or franchise: This is leverage in the purest form of multiplication. More copies of songs or CDs, more copies of software, more copies of books or DVDs, will all result in more profits for the owner of copyright or franchise.

These are the reasons that in Robert Kiyosaki’s four quadrant of E/S/B/I, B (business owner) is a better money-making model than S (self-employed) because of the multiplicative power. S relies solely on the available time of oneself, it has to be multiplied by a very high per hour rate to reach a good income level. However, using leverage is not risk-free at all even when you control your own business.

The other forms of leverage are financial leverages:

1. Margin: Margin power in stock is usually 2X your cash. Margin in forex trading can go up to 400X.

2. Asset-backed loan: mortgage debt.

3. Other loans that are not backed by assets: Credit card debt falls into this category.

4. Marketable options: These are call & put contracts in the stock or futures markets.

5. Employer’s granted stock options: It’s essentially a long term call option on the given stock.

The only leverage that I recommend pursuing are mortgage debt and stock options. The other ones like #1 and #4 are better for professionals. And the interest rate on #3 is usually too high to be worthwhile carrying, unless it’s for very short timeframe. The advantage of carrying a mortgage is explained in my post: “Why is your home the best investment?” Stock options (#5) are very good if you are fortunate enough to have them. Under non-bubble conditions, the value of stocks tend to go up along with inflation, and one should be rewarded with certain gain.