When Being Rich isn’t Enough

“So the haves are borrowing more to keep up with the have-mores. ”

Yet again, I have become facinated with this new trend that I have learned about on a Yahoo! article. This is the full article. The crux of the article is the fact that rich people (generally people with millions in the single digits) are using leverage and debt to significantly increase their wealth. It is an interesting concept and it makes a lot of sense. Similar to the people who borrow thousands of dollars in 0% balance transfer offers and then make money off of the interest, this is an example of people that work toward having tons of money in the stock market or other types of investments that pay large percentages, all the while they are paying a 6 or 7 percent interest rate.

Be Rich and Prosper

This is not something that is terribly shocking. In addition to the people who buy more than one real-estate property and then leverage that property to handle the payments/mortgage etc. as a means for paying their debt, people have also started using prosper this way. From the very beginning of using Prosper, the online person-to-person lending site, I’ve seen loan requests for anywhere from 5k to 10k to “re-invest” in prosper. People that are doing this are using their good credit as collateral in order to leverage debt to make more cash. But even a small amount can make good returns. For example, if you can manage to borrow 10K on prosper and then relend it back out and make at least 4% return over and above the original loan interest and collection fees, means that you will make about 400 dollars per year. Doing this is not for everyone though; not everyone is in the right place to finance this kind of activity.

The Danger of Leverage

The problem with leverage however is that it makes it extremely easy to move around heavy amounts of weight (or debt). Without the proper support and backing, it is easy to get into financial trouble. Financial Leverage is derived from the term in physics, leverage. Leverage is what is used when a car is jacked up with a standard pole jack. The nice thing about the car being worked on is that it is easy to do with the car “leveraged” in the air. But accidents can happen, and unless there is a good safety net, it is possible that the “leverage” could give out and crush you.

Similarly in personal finance, if the rent is not paid on a leverage property…if the loans are not paid on prosper, the leverage starts to work against you. And now instead of gaining income you are in fact losing it, paying tons of money over and above your regular expenses. You have to pay for the interest of the money you borrowed and you have to pay the money itself back.

Sub Prime Lending

Of course, now people who got over their heads in real estate, especially using leverage, are now in trouble. But so are the banks who funded the loans in the first place. As a result, much of that debt continues to be shuffled around in the form of bonds and the like among large banks and other financial institutions. Unfortunately, with a pile of dirt that size, there is not a rug big enough to sweep it under or a broom large enough to do the sweeping, even if a rug could be found!

Avoiding the Leverage Trap

Leverage can get everyone into trouble but the surest way to make sure that you are able to use this tool while still being responsible is to maintain a significant portion of your assets in liquid items that are not in danger of large fluxuations in price and ensuring that *if necessary*, those assets can cover the leverage you’re using. If you have 50K in cds and other assets, you might consider only leveraging 10-25k so that you are able to easily cover the leveraged loan if necessary.

In reality, most people misuse leverage. That is exactly what happened with some cases that are becoming so common and popular. Casey Serin of I am facing forclosure ran into this exact issue. With several houses at once, he was in multiple mortgages and was significantly over leveraged. This can be avoided if you ensure that you maintain liquid assets like bank accounts/cds etc in an amount of 2 or 3x what you plan to leverage.