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How the Rich Use Debt
Loyal reader, meet, Credit Card Connie.
Now, let's also meet Leveraged Larry.
Together, these two are going to help us understand how the rich use debt versus how the poor do.
Too many people succumb to victim mentality and tell themselves that the rich are just rich because they had connections, resources, etc. that weren't available to everybody else.
In reality, though, most wealthy people end up wealthy because they make distinctly different decisions throughout their life than poor people do. One of these decisions is typically the manner in which they used debt.
I know this because I saw it day-in-day-out in my day job as a personal banker. My wealthiest clients weren't superhumans. They simply made different financial decisions than the other customers I served.
Having a full understanding of how the rich use debt (and actually acting on it) can be one of the single biggest factors in your overall financial health throughout your life.
The tale described below will show you just how powerful this idea is. If you take this to heart and act accordingly, good debt can be the foundation for exploding your wealth.
A Word Of Caution
One footnote I want to mention is that there are some obvious oversimplifications below. I'm not using this example to be as precise as humanly possible.
Rather, I'm simply trying to show the power of leverage.
Accordingly, please take this example with a couple extra grains of salt.
Good Debt vs. Bad Debt
Let's make a couple assumptions.
We'll assume both Credit Card Connie and Leveraged Larry make $150,000 a year – a solid salary by most standards.
Next, let's assume both Connie and Larry each have $50,000 in savings.
A fork in the road
This is where things start to get different for Connie and Larry.
Connie rents an apartment in a new neighborhood with fancier homes and starts meeting some of her new neighbors.
She takes note of the cars her neighbors are driving, the clothes they're wearing, the places they're going on vacation and where they're going out to eat.
Connie becomes jealous and insecure. She decides she needs to start enjoying the same luxuries that her neighbors seem to be enjoying.
Meanwhile, things are going a little differently for Larry.
Larry was putzing around the internet the other day and came across an intriguing article talking about real estate investing.
Feeling inspired, Larry decides he wants to get started in real estate investing.
Fast Forward
Time flies.
Here we are a year later now. Let's check in with Connie and Larry.
Life is looking pretty good for Connie.
She now has a new Mercedes, she furnished her new home with some beautiful new furniture, and she's feeling nice and pampered after spending the last week in Europe.
All of Connie's new neighbors are impressed with her lavish lifestyle and she has tons of new friends.
But there's a problem starting to lurk under the surface…
This new lifestyle is damn expensive.
That Mercedes? Connie took $25,000 out of her savings as a down payment.
That furniture? There goes another $10,000.
Let's not forget the Eurotrip – another $5,000.
Suddenly, with the new car payment, her new habit of always eating out with friends, and the new wardrobe she's always maintaining, Connie's ability to save has all but vanished.
Leveraged Larry's Quiet Life
Let's check back in with Larry.
Life seems pretty boring on this side of town.
No fancy new car. No new furniture. No overseas vacations. No extravagant dinners.
While all of this may seem incredibly boring, Larry actually has something very exciting happening.
He's about to close on his first investment property.
After doing a little more research, Larry figured out that he wanted to focus on “House Hacking.”
He found the perfect property. It's a triplex that will allow him to live in one unit and rent out the other two.
The triplex costs $400,000.
Now, obviously, this is well above the $50,000 Larry has in his savings account.
Luckily, though, Larry understands leverage. After doing some research, he's discovered that you can actually use the expected rental income from a triplex to help qualify for a larger mortgage.
The appraiser that Larry's mortgage broker uses calculated that Larry can expect a total of $2000 per month in rental income between the other two units.
Because lenders will let you use 75% of this income, that increases Larry's income by $18,000 per year in his lender's eyes, bringing his total income to $168,000.
Larry decides to put 10% down since he's a first-time home-buyer. This leaves his principal balance at $360,000, his savings balance at $10,000 and his monthly mortgage payment at $2,491.82 including taxes and insurance. For even numbers, we'll round up to $2500 per month.
With his newfound rental income of $2,000 per month, Larry's suddenly sitting pretty. He has his monthly mortgage payment almost entirely paid for, only leaving $500 each month for him to pay.
To be fair, let's also assume Larry has about $200 in miscellaneous monthly expenses to keep the home in good shape. This brings his total out of pocket housing expenses to $700 each month.
Time for a Status Check
Let's take a look at some numbers to see how Leveraged Larry and Credit Card Connie are stacking up.
Let's assume the following monthly budgets:
Next, let's assume that after taxes, healthcare, and 401K deductions, both Connie and Larry take home 60% of their taxable income. This means each of them receives direct deposits of $7,500/month.
Here's where things get interesting…
Based on these numbers, Credit Card Connie can only save $1000 per month outside of her 401K.
Leveraged Larry? He'll now be able to save a whopping $5,300 every month, totaling a whopping $63,600 per year.
By staying disciplined, living small, and understanding how to use debt strategically, Larry will already be capable of buying another investment property just a short year from now.
Looking Ahead
Let's check in at the end of each of the following 5 years.
A couple of assumptions I made here:
- Net worth is defined as everything outside of Connie and Larry's 401Ks, which we'll say grow at the same pace for each of them.
- Income stays at a constant $150,000 for both Connie and Larry
- Larry acquires a new rental property once a year at a price of $400,000. Each time he does this it adds $300/month to his savings ability, totaling $3,600 per year.
- Even though, as you'll see, Larry quickly gets to the point where he could buy more than one property per year, we'll say he instead chooses to just invest in the stock market with the extra money.
- The stock market is where both Larry and Connie keep all excess cash. They each receive a 7% annual return on this money.
- Larry is also able to take advantage of equity gains in the form of paying down the principal on his various mortgages. Again, to dramatically simplify this, let's assume no growth in property values. I'm taking the principal paydown figures directly from the mortgage calculator link I included earlier.
- Lastly, we're going to assume that spending stays constant for Connie and Larry respectively in each of the 5 years.
Viewing the chart above, you can see Connie's growth is pretty straightforward.
Each year she contributes $12,000 to her brokerage account and receives a 7% rate of return, ultimately netting her $83,034 in savings by year 5.
No small sum, but let's look at how she could have done better had she understood the power of leverage.
Leveraged Larry, by living small and magnifying his investing ability through mortgages, is able to get himself over halfway to being a millionaire in 5 short years.
Let's break down Larry's impressive growth
We start in year 0 with Larry having just purchased his first property.
This gives him $10,000 in his brokerage account and $40,000 in equity, equating to a $50,000 net worth.
Over the course of the next year, he's able to increase his net worth by $69,853.47. Here's how:
- He earned $700 in interest on the $10,000 invested in his brokerage account.
- He saved $63,600 as explained in the earlier chart. $40,000 of this ends up going to fund the d0wn payment on his 2nd investment property at the end of the year.
- He paid down $5,553.47 in principal on the loan for his first investment property.
Not too shabby for a year's time…
This gives him a total net worth of $119,853.47 with the following breakdown:
Now let's look to the following year.
Larry once again sees impressive growth. He's able to increase his net worth by $81,464.26. Here's how:
- He earns $2,401 in interest on the $34,300 in his brokerage account.
- He saves $67,200, which is his regular annual savings of $63,600 plus the extra $300/month he's now able to save thanks to property number two. Again, $40,000 goes towards his next down payment.
- He paid down $6,309.79 in principal on property #1's loan and $5,553.47 in principal on property #2's loan.
Larry's net worth now stands at an impressive $201,317.73 with the following breakdown:
Now that you see the breakdown of how his wealth is growing each year, let's summarize the following three years:
Now here's the crazy part…
The stunning power of compound interest has barely started to take effect here.
If we were to continue this chart out over 40 years, Leveraged Larry would end up with an incredibly substantial net worth.
Credit Card Connie simply cannot keep up.
Conclusion
Ultimately, this example is an oversimplification in many ways.
Nevertheless, it drives home the point that if you want to pour jet fuel on the process of building your wealth, you need to get comfortable using leverage.
The rich use debt in a very strategic way. They only use it to purchase income-producing assets – never to buy the hot new car (at least not until later in life).
When you not only understand this but also actually capitalize on it (pun intended), the entire trajectory of your wealth changes.
Hopefully this post was helpful in your journey to building financial freedom. If so, consider subscribing below so you stay up to date whenever we upload a new post.
Also, be sure to drop a comment down below with your thoughts. Let me know if you think I went wrong somewhere in my assumptions or if you have different feelings on debt.
As always, until next time, enjoy!
-Alex
About the Author Alex Owens
Alex is a serial entrepreneur, coach, and active investor who drives growth and scale for his portfolio companies.
