The Power of Leverage: How Smart Investors Use Debt to Build Wealth
The Power of Leverage: How Rich People Get Wealthy Using Debt to Multiply Money
Some of the richest people in the world have debts of ₹3.5 lakh crore (Mukesh Ambani) and ₹3.36 lakh crore (Gautam Adani).
People that promote the narrative of cash buyers as the true and pure representation of the "rich" or "generationally wealthy" buy everything in cash, think that having no debts is something to be proud of, for the same reason.
There is a misconception among the financially illiterate about the role of loans, and how they play a major part in cash flows, that they can use to their advantage.
We begin by laying out some financial jargon to understand
- Cash Flow: Net cash flow coming in or out of your bank balance.
- EMI: Equated Monthly Installment.
- Nifty Index Fund: Mutual fund that replicates the Nifty 50.
- Moderate Returns: Average annual returns from a particular stock/fund over a given period.
Now, for equity, moderate returns would be around 12% per annum.
The Cash Buyer vs. the Smart Investor
Let me present you with a hypothetical scenario where both the investors have ₹1 crore liquidity, in addition to which, they earn another ₹1.5 Lakhs every month.
The Traditional Cash Buyer's Approach
The traditional cash buyer would use the ₹1 crore cash to buy a home/flat with no loans, as he has enough liquid cash to pay for it fully.
He would earn ₹1.5 lakhs income from his business, while having 0 liquid cash to invest.
The Smart Businessman's Approach
The smart businessman will use the leverage of home loans and take two flats, pay ₹20 lakhs as down payment each (₹40 lakhs total), and ₹80 lakhs for each flat as a home loan (total loan amount: ₹1.6 crores).
The smart businessman will pay 30% of his income in tax and invest the remaining 70%, which will be roughly ₹1,05,000, in a Nifty Index Fund.
Let's Analyze His Cash Flow After Paying His EMIs
The smart businessman has taken a total of ₹1.6 crore in home loans. This means that roughly ₹1.33 lakhs will be due every month as an EMI, which he finds himself unable to pay, as he only earns ₹1.5 lakhs in salary every month (not counting the income from his business).
However, the businessman is able to live in one of the flats as a residence and rent out the other for a price of roughly ₹60,000 per month (1 BHK in Mumbai).
Therefore, the businessman will be able to use ₹60,000 of rental income to pay off his EMI.
The total EMI of ₹1.33 lakhs minus the rental income of ₹60,000 results in a net EMI to be paid by the businessman of ₹73,000.
The businessman will be able to afford this amount of EMI fully with his ₹1.5 lakhs salary (from the earlier step, we know that he has roughly ₹1,05,000 in cash available to him after tax) by allocating ₹73,000 to his EMIs.
Therefore, the smart businessman effectively manages his cash flow and has two homes on his hands, with some liquid cash to spare to invest in a Nifty Index Fund.
The Situation 20 Years Later
Twenty years later, the tenure for the home loan closes for the businessman, and he effectively has two homes and the liquid cash he had to spare from allocating ₹73,000 to his EMIs every month.
The traditional cash buyer has one home and little to no liquid cash.
The smart businessman has ₹5.15 crore 15 lakh in liquid cash from the ₹60 lakh he allocated to the Nifty Index Fund, as mutual funds give moderate returns of roughly 12% per annum.
The businessman turned ₹60 lakh into ₹5.15 crore 15 lakh (including the amount he allocated) in 20 years with smart financial management.
By taking a smart decision and using the leverage of a home loan, the businessman was able to turn ₹1 crore (the amount allocated to the home purchase) into ₹5.15 crore, and the ₹40 lakhs allocated as a down payment he turned into ₹2.06 crore.
Whereas, if he would've paid for the home in cash, the businessman would not be able to perform these actions.