real estate investing

Where to Invest Your Money After You've Maxed Out Your Retirement Account

Tim Lemke — Tue, 10 Apr 2018 08:00:06 +0000

Are you a super saver? Have you managed to contribute the maximum amounts allowed into your 401(k) or individual retirement accounts? If so, you may now be wondering what to do with any additional money you have. Should you continue to invest? If so, how? Should you spend it on a Picasso painting or give it to your kids?

There are many options for people who have maxed out their retirement contributions. Here are some of them.

Taxable brokerage account

I'm a huge fan of the tax-advantaged nature of retirement accounts, but regular taxable brokerage accounts have their good qualities. For one thing, they are more flexible than retirement accounts. There is no limit to what you can invest in a taxable brokerage account, and while you will pay tax on any dividends and capital gains in these accounts, there is no additional penalty for withdrawing money before you retire. If you collect dividends from investments in a taxable brokerage account, they can be a great source of extra income.

Real estate

If you've put as much money into retirement accounts as you can, why not take a look at buying a property or house as a possible investment? Real estate can appreciate in value just like stocks, and you may even be able to draw income from tenants as well.

Investing in real estate is obviously different from investing in stocks or bonds. In this case, you are investing in actual property. There may be more costs upfront, and you may face the expense and work associated with managing it. But there are many people who have gotten wealthy by buying and selling properties.

It's worth noting that under the new tax law, you can't claim a tax deduction for mortgage interest from a second home. But the potential for real estate to rise in value and generate income is still a powerful thing. (See also: The Only 5 Rules You Need to Know About Investing in Real Estate)

Peer-to-peer lending

Did you know it's possible to make money directly off other people's borrowing? With peer-to-peer lending, an individual can use an online platform to purchase someone else's debt and make money off the interest payments. The money you can earn is based off the riskiness of the loan; more creditworthy borrowers will pay out less than those with worse credit.

There is always the risk of borrowers defaulting on loans, but most lenders have found good returns by purchasing a "portfolio" of loans at various risk levels. Lending Club and Prosper are two of the most popular peer-to-peer lending platforms. (See also: How to Make Money With Peer-to-Peer Lending Service Prosper)

Education savings accounts

If you have children or other relatives that will be going to college, you can help fund their education and receive some tax benefits for yourself. A 529 college savings plan is a popular option, because it allows someone to invest money and withdraw the gains tax free, provided the funds are used to pay for college. In many instances, the contributions are also deducted from your taxable income. The new tax law allows 529 plans to be used for other education expenses, such as private high school, as well. (See also: The 9 Best State 529 College Savings Plans)

The bank

It may seem silly to just put money in a simple savings account when interest rates are still quite low. But it's possible that, in an effort to max out your retirement accounts, you've been neglecting your cash savings. Having a good amount of cash on hand can give you a nice cushion in the event of an emergency and prevent you from raiding your retirement accounts. If you don't have at least three months' worth of expenses saved, it's a good idea to bolster that savings. Once you hit three months' of expenses saved, go for six. (See also: The Best Online Savings Accounts)

It's actually not uncommon for people of high net worth to have cash flow problems, because they focus so heavily on investing their money. If you are maxing out your retirement contributions, you're doing great. There's really nothing wrong with having more cash on hand than you may need, and you may find that it gives you some nice peace of mind.

Collectibles

I am personally not a huge fan of collectibles as an investment, but they can be useful as part of a broad portfolio. A savvy, knowledgeable collector can make good money on things like art, antiques, trading cards, or even classic cars. And collecting can be good fun. Just be aware that the returns on collectibles rarely top what you can get in the stock market. (See also: 10 Collectibles That Almost Always Become More Valuable)

Donations to charity

You may think that once you've maxed out your retirement contributions, there are no more tax breaks to be had. But you can get a tax deduction for donating to most charities. So you can feel good about supporting a worthy cause while helping yourself financially.

The one caveat here is that under the new tax law, it may be financially smarter for people to take the standard deduction rather than itemize. This could make donating to charity less advantageous from a tax perspective.

Gift it to family

If you are very wealthy and expect that your children or other family members will inherit your money when you die, it may be a good idea to begin transferring that wealth now to avoid taxes. Under the new tax law, the exemption for gift and estate taxes — the amount you can give away in your lifetime — is $11.2 million per individual. Married couples can transfer double that amount, or $22.4 million. It's also possible to make an annual gift of up to $15,000 per person (married couples can gift $30,000 per recipient) without paying taxes.

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This article is from Tim Lemke of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

4 Ways to Protect Your Retirement From Inflation

Dan Rafter — Fri, 03 Nov 2017 09:00:06 +0000

When you're saving for retirement, it's easy to forget that the goods you'll be buying years or decades from now will probably cost more, all thanks to inflation. It's important to keep this in mind when planning the amount of money you'll need during your after-work years.

Here are five ways you can inflation-proof your retirement savings:

Don't be too conservative

It can be tempting to stow a greater percentage of your retirement income in low-risk bonds, especially as you get nearer to your retirement date. And bonds certainly should be part of your retirement portfolio. But too many people focus too much on bonds. They don't look at the real return on these investment vehicles with the effects of inflation factored in. Because bonds are less risky, they also offer lower rates of return.

Say a bond has rate of return of 6 percent. If inflation is at 3 percent, that rate of return is really only 3 percent — a fairly low payoff.

That's why it's important to include some riskier investments, such as stocks, in your retirement savings plan. Yes, there is more risk that stocks will lose value. But stocks also have the potential of providing a far higher rate of return; one that will help overcome the rising costs that come with inflation. (See also: 7 Reasons to Invest in Stocks Past Age 50)

Do your research

Investing in just any group of stocks won't help you overcome inflation. Certain companies and financial sectors thrive when inflation rises, while others tend to struggle. For instance, investing in retail stocks might not help you overcome inflation. That's because retailers tend to struggle when high inflation makes the products they are selling unattractive to consumers. However, companies in the agricultural sector tend to do better when inflation is higher. Their stocks, then, are a better hedge against a rising inflation rate.

Invest in treasury inflation-protected securities

Treasury inflation-protected securities, better known as TIPS, are designed to protect investors from inflation. That's because the return is tied to the Consumer Price Index. This is an especially useful tool for investors living on a fixed income, like retirees.

Say you invest $100,000 in TIPS. If inflation is 4 percent, your principal balance will now be worth $104,000 after a year. When TIPS reach their maturity date, investors get back either their original principal amount — what they originally invested — or one that's been adjusted for inflation, whichever is greater. TIPS also provide a bit of interest income, paying this out every six months. Investors don't have to pay state and local taxes on this interest or on the growth in principal, but they do have to pay federal taxes on that money earned.

Investors can purchase TIPS at no cost from the U.S. Treasury in $100 values. You might also be able to invest in TIPS when you invest in a mutual fund that includes them as part of their investment mix.

Invest in commercial real estate

The value of commercial real estate can continue to rise even if the stock market is struggling. By including investments in commercial real estate along with stocks in your retirement savings portfolio, you can build a diverse investment mix that you can then use as a hedge against inflation.

The easiest way to invest in commercial real estate is to put your money in a real estate investment trust, or REIT. With a REIT, you'll be pooling your money alongside other investors in commercial real estate buildings such as offices and apartment properties. You can also invest in a mutual fund that includes commercial real estate assets among its investment mix. (See also: The Only 5 Rules You Need to Know About Investing in Real Estate)

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This article is from Dan Rafter of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

3 Smart Ways Young Millionaires Manage Their Money

Shannah Game — Fri, 09 Sep 2016 10:30:15 +0000

If you're lucky enough to wake up tomorrow as a young millionaire, it's time to learn a few tips to keep your wealth working for you. Here are three ways that financially-savvy millionaires under 40 manage their money wisely:

They Use Buckets

Good financial planners will tell you that it's not so much about the amount of money you have, but about how you spread that money out. It's a concept called diversification, and it doesn't just apply to your 401K mutual funds.

Millionaires under 40 understand can't rely on just one approach to save and grow their money. Instead, many young millionaires build an investment portfolio with the traditional securities, such as stocks and bonds, but also add in less-traditional investments like real estate, and other alternative investments.

Real estate is an excellent example of how young millionaires use buckets. They might hold a REIT (Real Estate Investment Trust) in their investment portfolio, and also have rental income streams that aren't tied to their job. Rental income provides an extra source of income that can be used for many smart purchases to grow even more wealth, like investing in a business or starting a small business to diversify further.

The best part of utilizing buckets is you're spreading your risk to avoid an all-out Bernie Madoff situation with your money. What young millionaires know is that if one bucket isn't performing, they can either reduce the exposure in that bucket or look to another bucket for growth or cash flow.

They Have a Cause

Millennials love a good cause. They're passionate and want to know that their money and time are going toward helping the greater good. Whether it's building an orphanage in Africa, rebuilding a community after a natural disaster, or marching in Washington to champion a cause, young millionaires believe in benefiting society.

There are many different options for socially responsible investing that young millionaires are incorporating into their financial plan. Most investment platforms now offer a selection of funds that either exclude certain companies, like oil and gas, or are inclusive of companies that focus on environmental or socially responsible products. Whatever your cause of choice is, there is a socially responsible investment to meet your needs.

They Are Curious

Most millionaires under 40 understand the importance of a financial adviser. When you get to the millionaire status, you probably also have a good lawyer and CPA on your "team." However, millionaires under 40 stay curious. They don't just rely on the advice of one person. They search for answers to money questions and read articles to find any other gems that might help them grow their net worth. They talk to friends and family about wealth as well.

It's a constant cycle that proves to be very successful with millionaires under 40. They understand that you need to spread your money around in different buckets to limit risk and maximize your growth potential. They become passionate about causes and want their money to make a difference in the world. At the end of the day, they stay restless and curious about finding more answers, asking more questions, and being ready to jump at opportunities.

Do you adhere to any of these — or other — precepts for managing your money?

This article is from Shannah Game of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Real Estate Investing Is Cheaper and Easier Than You Think

Joshua Dorkin — Thu, 06 Feb 2014 11:24:42 +0000

Real estate often seems to be the "ugly stepchild" of the personal finance community.

Most individuals understand that there is something there, but don't talk about it because it appears mysterious, complicated, and only for the super rich. However, I believe real estate investing can be used by anyone looking to broaden their financial outlook and can add significant potential for building wealth to their plans. (See also: 5 Investing Basics)

It's not just for the rich.
It's not just for the old.
It's not just for the risky.

Real estate investing can be right for you, now. It can take years off your day job, add thousands to your net worth, and be a lot of fun. This post is going to explore the basic process for getting involved with real estate investing and hopefully, will take some of the mystery away so you can see real estate for what it is: an opportunity.

Why Invest in Real Estate?

First, let's talk about why you should even get involved with real estate in the first place. For me, there are several key reasons.

1. Leverage Helps

Remember as a child when you played on the see-saw and you discovered that by sitting further back or closer to the center, you could affect how much weight you could lift? (Am I the only one with that memory?) Or perhaps you've heard the famous quote from Archimedes who said, "Give me a lever long enough and a fulcrum on which to place it, and I shall move the world."

The point is, leverage is the ability to use a small amount of force to move a much larger object. In real estate, the same principle is true in terms of cash. By using just a small amount of cash (a down payment) you can control and reap the benefits (and the risks) of an entire property. In other words — if you wanted to buy $100,000 worth of gold, you would need to have $100,000. However, you can buy $100,000 worth of real estate with far less than $100,000 — sometimes as little as nothing down.

2. Investor Control

Second, I love real estate investing because it's an asset class that I can control. When Google, Apple, or one of a million other stocks go up or down, there is little I can do about it but buy or sell. I have practically no say in how that stock actually moves. However, I fully control my real estate investments and the success or failure of that investment is on me — not a board of directors I have never met. (See also: Quick Ways to Know If You Should Invest in a Company)

3. Investment Variety

There are a lot of different ways you can invest in real estate, which we'll cover more specifically in a moment. The benefit of this is that you will be able to find an investment strategy that works for you, that will fit your personality, and which will work within your time schedule. There is an absurd amount of variety within real estate, which makes it even more fun to deal with.

4. It's a People's Game

Yes, there are avenues to invest in real estate on paper only — but I love the diversity of it. I'm not just looking at numbers on a page — I'm looking at real people, real money, real life.

5. Profit Today and Tomorrow

Finally, one of my favorite aspects of real estate investing is that when structured correctly, real estate can boost your checking account both now and in the future.

How Is Money Made With Real Estate Investing?

Asking this question is a bit like asking "how do Americans make money?" There are numerous different avenues to create wealth and income with real estate, and as I mentioned earlier — much of it depends on your personality and the way you want to run your investments. However, the following four streams of wealth are the most popular methods you'll see today.

1. Cash Flow

Cash flow is the income that is left in your bank account after all the bills have been paid. This is the profit you make each and every month from your rental portfolio. For example, if the rent on a property was $1,000 per month, and all the bills came to $800 — your cash flow would be $200 per month. It's basic addition and subtraction, but this one concept can change lives. Imagine receiving $200 per month in cash flow. Pretty great, but not life-changing in any regard. However, imagine receiving $200 per month per unit in cash flow. Suddenly, the picture changes. (See also: Should You Become a Landlord?)

What if you bought two rental houses?
What if you bought a fourplex?
What if you bought a 100 unit apartment building?

Suddenly, we're talking about some pretty serious dough here! Obviously, most people don't jump from owning nothing to owning a 100 unit apartment complex, but the math is the same no matter the scale of the property.

To top it all off — remember the concept of leverage from earlier? You don't need millions of dollars to start making monthly cash flow from real estate investing, when you have the right leverage applied. And don't get me started on how powerful "compound interest" is when you start to recycle this cash flow back into more investments!

2. Appreciation

The second way people build wealth in real estate is through appreciation — the rising of property values. In the past, I believe investors placed far too much emphasis on appreciation and not enough on cash flow, so when the real estate market collapsed several years ago, a lot of people lost their shirts.

However, when you combine the potential for appreciation with the stability of great cash flow, you are pulling out a double barreled shotgun that can do some awesome things. Imagine holding on to your property, which is providing $200 per month in cash flow, until the market doubles in value. It might take 5 years, it might take 10 years, it might take 20 years. The point is — you are okay either way and you are building wealth every month. Now, appreciation isn't guaranteed, but over time, we can assume that in a great number of cases, you'll see some kind of positive appreciation unless the market you're investing in is severely depressed. (See also: Ways to Boost Your Home's Value)

Furthermore, each and every month you hold onto the property, your loan balance decreases, so in essence — your tenants are paying down the mortgage for you automatically. If nothing else, in thirty years (or less, depending on how long your mortgage was for) you'll own the property free and clear!

3. Flipping

If you've ever watched one of the "flipping" TV shows, you'll recognize this strategy. House flipping is the process of buying a distressed property, rehabbing it, and reselling it — hopefully making a profit on the difference. Flipping can be one of the more risky ways to invest in real estate but with some of the highest potential for financial reward. Although flipping is more closely associated with the "buy low, sell high" model of a retail shopping store, many of the same real estate investing principles are used to make a profit in this line of work.

4. Return on Investment

Up until this point, we've dealt primarily with the more "active" forms of investing in real estate. However, many others choose to invest in real estate from a purely "passive" viewpoint, focusing instead on simply earning a good return on investment for their money. Primarily, there are two common ways to make this happen.

REITS: A REIT, or Real Estate Investment Trust, is a security that can be bought and sold like a stock, but that uses the raised funds to invest in real estate, primarily large commercial properties. REITS can invest in either property directly, or in mortgages on property that other investors own, and the best part is that by design, they are required to pay out a dividend.
Notes: Other investors invest in Notes (also known as "paper" or "mortgages") to earn a solid return on investment. You may have had some experience with this in the past if you've ever had a mortgage on your own home "sold" to another company. Mortgages are bought and sold all the time, though the borrowers seldom recognize this because it doesn't affect them.

Making a Plan

Let's move from the theory and jump into some of the practical ways you can get started investing in real estate. Although you may be excited to jump in and start buying property, the first step is actually to sit back, relax, and make a plan.

A plan is like a road map — it tells you the best way to get from A to B and how to avoid the dead ends, tourist traps, and potholes.

1. Get Educated

Step one in creating a road map begins with gaining a solid education on what you want to do. I'm not advocating spending thousands of dollars to go to some special school or training program, but at least spend some time reading real estate books, listening to real estate investing podcasts, or chatting with other real estate investors. By sinking into the education, you will create a solid foundation to build upon. I'm staunchly opposed to buying the latest get rich quick manual or joining some expensive bootcamp or course from the guru of the hour, however. There are plenty of great ways to learn real estate without breaking the bank — do your homework and you'll find them. (See also: 21 Real Estate Terms You Need to Know)

2. Choose an Investment Type

Step two in your plan is deciding what kind of investment you want to buy. There are numerous different choices you can pick from, including:

Vacant Land
Single Family Homes
Small Multifamily Properties
Large Multifamily Properties
Commercial Real Estate
Mobile Homes
Notes/Paper/Mortgages
...and more.

The more time you spend educating yourself on the different types of real estate, the more you'll find yourself drawn to certain types that fit your personality, time schedule, and checkbook. (See also: How to Evaluate a Neighborhood)

3. Determine Your Goal

Finally, look at the place you want to arrive at. Is it a million dollars in the bank? $10,000 per month in cash flow by the time you retire? Whatever your goals are, write them down. Then, simply work backward, using the knowledge you gained from your education to determine what you need to do to get there.

For example, if your goal is $10,000 per month in passive income in the next twenty years — and your plan is to buy single family homes that cash flow $200 per month, how many houses do you need? How many is that per year? How much down payment will that require each year?

To learn more about getting started with real estate investing, check out The Ultimate Beginner's Guide to Real Estate Investing that we put out earlier this year.

Real estate investing can have a tremendous impact on your financial future if you take the time needed to learn how to best get started. Whether you have millions in the bank or just getting started — I believe real estate investing can and should be a significant part of your portfolio. Use this post as a springboard to your education.

The more you learn about real estate, the more you'll see it's not the ugly stepchild of personal finance, it just might be your new best friend.

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Guest Post Blurb:

Joshua Dorkin is the Founder and CEO of BiggerPockets.com, the real estate investing social network, marketplace, and information hub, and is the host of the popular BiggerPockets Podcast. Josh built BiggerPockets to help find answers for his own real estate investing questions, and in the process has helped millions of others.

This article is from Joshua Dorkin of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

How to Build Wealth in a Depressed Economy

Mark — Thu, 28 Oct 2010 13:00:12 +0000

The current economic environment has led many investors to become pessimistic about the United States' economy. Consumer confidence is low and unemployment is running high. But as Warren Buffett has often noted, economic recessions are when investors can find some of the absolute best opportunities.

Let’s take a look at a few ways to build wealth during the current downturn. (See also: 5 Money Lessons From Millionaires)

Invest in areas where no one else is

One of the easiest ways to lose your hard-earned dollars is by following the crowd. Fear is causing many investors to rush to the safety of Treasury bonds and gold. These assets do have some value, but they are not the best opportunities right now. The time to rush into gold was when no one was buying it at $300 or $400 per ounce. Gold now trades at nearly $1,400 an ounce. You never want to chase an investment when it is trading close to its all-time high valuation.

Investors looking for a nice return should turn their attention to the assets that investors are avoiding. Stocks and exchange-traded funds (ETFs) in the financial sector have been underwater for years now. Many technology stocks are still trading at prices below their true value. The steel and industrial production sector contains some great values as well. These investments are long-term holds that could reap serious rewards for risk-taking investors.

Build another income stream

Unemployment may be running high, but that shouldn’t deter you from starting your own company. A bad economy is the perfect impetus for starting an online business. There are needs for temporary agencies, consultants, and webpreneurs. All of these businesses require very little overhead and can be started from the comfort of your own home. Most just require paying a few bucks for a domain name to get started.

A part-time job can also add a little income. You can do freelance writing or design work for other companies and bring in an extra couple hundred dollars a month. You can start you own catering business or run errands for people in your neighborhood. If you love pets, then start a pet-sitting business. Your entrepreneurial venture could end up turning into a full-time job.

Buy residential real estate

The real estate market looks like an absolute mess right now. Foreclosures are peaking and home prices continue to be depressed. Every market pundit is predicting more pain for the real estate sector. But while the market may be tough now, but there are signs that the sector may finally be reaching bottom.

Mortgage rates are the lowest that they have been in decades. This could help entice some homebuyers and real estate investors back into the market. Remember back in 2009 when everyone was so pessimistic about the stock market? The market reached its low early in 2009 and has bounced back nicely. Many investors missed the rebound waiting for another market drop.

The same thing could be setting up right now in the real estate market. Everyone is waiting for commercial and residential real estate to hit bottom. The truth is that no one can tell when a market is at its lowest point. Investors with the capital should consider getting in these markets now, as they are much cheaper than they were just a few years ago.

Remember that during a bad economy can be the best time to implement your wealth-building strategy. Just because the economy is in a downswing doesn’t mean that you cannot emerge from these difficult times in better financial shape than you entered them.

Guest Post Blurb:

This is a guest post by Mark. Mark publishes his own financial blog at Buy Like Buffett. He is a registered investment advisor and has written financial columns for Baltimore and Washington D.C. area newspapers. Read more by Mark:

This article is from Mark of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Top 10 Real Estate Tax Write-Offs

Brian Davis — Wed, 10 Mar 2010 15:53:22 +0000

As real estate values have fallen and foreclosures have swamped the market, increasing numbers of would-be sellers are deciding to lease their properties instead of selling. These new and reluctant landlords often miss out on massive tax deductions available for investment properties, which can save thousands of dollars in taxes. In an economy where every penny counts, make sure you take advantage of these ten real estate tax write-offs, some of which are exclusive to real estate investors and landlords.

1. Mortgage Interest

Even homeowners can write off mortgage interest, so this deduction is widely known and understood, but mortgage interest can add up to many thousands of dollars each year; not a deduction to miss.

2. Hazard Insurance

If you were a reluctant landlord, you can rejoice over this one: homeowners can't write off their homeowner's insurance, but landlords and real estate investors can write off their hazard insurance premium as a deductible expense. Be sure to save a copy of your insurance premium invoice, and give it to your accountant.

3. Property Taxes

As intuitive as it sounds, thousands of property owners forget to list their real estate property taxes as deductible expenses every year, and end up effectively paying those taxes twice.

4. Property Depreciation

Real estate depreciation is not well understood, but it adds up to a substantial sum each year. Basically, the government allows real estate investors to take a "paper loss" of value on a mathematical model that assumes that properties will steadily decline in value over 27.5 years, from their purchase price to a value of $0. This means you can deduct a depreciation loss of 2/55 of the purchase price, for the first 27 years you own a property. Depreciation can become complicated however, so make sure you discuss this one with your accountant.

5. Legal Counsel & Landlord Forms

Most of the legal bills, including the cost of landlord forms and real estate legal contracts, are tax deductible for your investment property. Important exception: eviction costs, which generally cannot be deducted, but speak with your accountant for further details on exactly which expenses can and cannot be deducted.

6. Property Management Costs

If you've hired a property management company to oversee your tenants, leases, and properties, their costs are tax-deductible, so be sure to add up their fees and write them off (and remember that you'll owe the property manager a 1099 if the total fees were over $600).

7. Private Mortgage Insurance (PMI)

If you have a high mortgage relative to your property's value (and right now, who doesn't), chances are you pay an extra charge each month for private mortgage insurance along with your mortgage payment. These charges, while annoying, can at least be deducted from your taxable income.

8. Maintenance & Repairs

While homeowners can't write off their home improvements, landlords and real estate investors can! There are some exceptions (so touch base with your accountant), but in general any repairs that are required for habitability and safety are tax-deductible.

9. Advertising & Tenant Screening

When landlords have vacant properties, they can write off the costs associated with filling them, such as advertising the rental property, pulling credit reports, obtaining criminal background checks, etc.

10. Settlement Costs

If you're one of the rare and lucky people actually buying investment properties right now, some of the settlement costs you pay can be deducted, such as mortgage lender fees and government recordation costs. Not every settlement charge is tax-deductible, however, so be sure to send a copy of your HUD-1 settlement statement to your accountant so they can comb through it and find all of the deductible costs.

As a final note, remember that your accountant's bill is deductible as well, on next year's tax return, so be sure to include last year's accounting bill among this year's tax deductions, and good luck saving money on taxes!

Guest Post Blurb:

This is a guest post by Brian Davis. Brian is a landlord and real estate investor, who contributes educational content for real estate investors to dozens of websites, and consults for EZ Landlord Forms. Read more articles at EZ Landlord Forms:

This article is from Brian Davis of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Borrowing to Invest: Helpful or Hurtful?

Nora Dunn — Wed, 17 Oct 2007 22:41:10 +0000

Philip's recent article entitled Good Debt Bad Debt sparked quite a debate as to whether any debt can be considered good debt.

And as far as being in debt for luxury items or non-essentials goes, I agree that carrying debt is a bad habit to get into. Interest dollars paid each month are going down the drain to help you pay for items that in many cases have already been consumed.

But to carry debt that enables you to earn money is a concept called Leveraging, and can be very effective in building wealth, businesses, and incomes.

Mechanically speaking, leveraging is the act of using a lever to gain a mechanical advantage or additional power.

Financially speaking, leveraging is similar. Dictionary.com defines it as:

The use of a small initial investment, credit, or borrowed funds to gain a very high return in relation to one's investment, to control a much larger investment, or to reduce one's own liability for any loss.

There are a number of ways to leverage your money, some of which you may already utilize:

Home Ownership

This is the most common form of leverage, however it isn't truly a leverage in the same way since you aren't borrowing to earn an income. But in its most basic form you are leveraging your way into your new home with the use of a mortgage.

For simplicity's sake, I'll illustrate the effectiveness of leveraging into home ownership with round numbers. You put $10,000 down on a $100,000 house. This house appreciates in value 2% over the next year. If you were to sell the house after a year, you would walk away with $102,000 (commissions and other erroneous expenses aside). Thus, in one year, you made $2,000 on your initial investment of $10,000. So although the house itself increased in value only 2%, your personal return on investment (ROI) was 20%.

This is a case often used in favour of buying a home as opposed to renting. Not only are you building equity as you pay off your mortgage, but you own and are reaping the benefits of an appreciating asset that would normally be beyond your reach to own outright.

The Down Side: If your home depreciates in value beyond the equity you have managed to accumulate, you could end up in a pickle. I have a friend who purchased a home for $200,000 with $10,000 down, got divorced two years later and had to sell the house. Unfortunately during that time the housing market crashed, and he could only sell the place for $170,000. So taking into consideration his down payment plus equity accumulated in the two years, and subtracting sales commissions eating into his proceeds, he sold the house with nothing to show for it but $25,000 in debt.

Business

If you have dreams of being in business (especially one that involves a storefront of sorts), you usually have to come to grips with the idea of being in debt. To purchase a franchise can cost anywhere from $20,000 to $2,000,000 just to get started. And walking into the franchise office with $2 million in cash is a rare occurrence, indeed.

However business debt is also good debt, as it is a truer form of leverage. You are engaging in the act of borrowing money with the expectation of earning an income, which makes the interest on that loan tax-deductible.

You are also making a down payment on an asset that not only provides you with an income, but also might appreciate capitally.

Similar to above, you invest $10,000 down on a $100,000 business. (This is a very simple example, of course). The business kicks off an income of $10,000/year. You can use this income to help make loan payments, which is a great way of making the debt pay for itself. But depending on the business, you may also find that there is a capital appreciation. For example as you build up a loyal customer base and good reputation, or if you own the underlying property, you may well be able to sell the business for more than the $100,000 you bought it for. This gain on the overall amount can again be expressed as a larger return on your investment of the initial $10,000 plus loan payments.

The Down Side: As with home ownership, if the business goes belly-up and there's nothing to sell, bankruptcy could very well be imminent. This is the inherent risk of owning a business, especially one that requires a capital outlay to get started. There are many tales of business owners losing everything they have, but also just as many about business owners who are earning incomes, plugging away at their loans, building equity in the business, and creating a retirement nest egg in addition to fulfilling a dream. And even a few tales of wild riches achieved with good business investments. Nothing wagered, nothing gained.

Investments

Although investments don't produce an income in the conventional "salaried" sense, many can indeed be income-producing for the purposes of leveraging. And again since you are borrowing money with the intention of earning an income (whether or not you actually do earn income, at least initially), the interest on the loan is tax-deductible.

The appeal behind investment leveraging is best when the interest rates for borrowing are low. For example, you borrow $100,000 with $10,000 down at 4% interest, and turn around to invest that $100,000. The 4% interest is a tax deduction, which means your net interest expense out of pocket is closer to 3%. Your investment then needs to make more than 3%/year in order for the leveraged loan to work out.

If your investment makes 8% or $8,000, and you subtract the $3,000 in net interest expenses, your gain is $5,000. If you express the $5,000 as a return on your investment of $10,000, you just made a 50% return!

The Down Side: Although the gains are magnified with investment leveraging, so too are the losses. If your investment loses 8%, then your net return on investment (taking into account interest paid) is over a loss of over 100%! However investments tend to trend upwards given a long enough time frame (8-10 years at least), so even initial dips in the market can be recouped significantly and the leverage strategy can work. But a long time frame and investment perspective are very necessary ingredients for this recipe to work.

Real Estate Investments

The concept of leveraging into real estate investments is a combination of the Business and Home Ownership strategies of leverage. Similar to the Business strategy, you are borrowing money with the intention of making an income (being rental income). So again the loan interest is tax-deductible. And with the real estate ownership, you are also banking on the appreciation of the asset in question to increase your return on investment.

The Down Side: If you can't find tenants to help you pay the mortgage, then you'll have to come up with the cash somehow yourself. If your resources are tight that might be a stretch. Real Estate market losses are also a risk when it's time to sell.

Risks and Notes to Potential Leverage Candidates:

Have extra cash on hand. This is good for covering loan payments when expected income isn't forthcoming.
Make it a long term investment. Since both gains and losses are magnified when leveraging, you need to allow a proper time frame for the asset to appreciate and recover from bumps and corrections in the market.
Do your due diligence. Meet with your financial planner, real estate agent, or business mentor. Ask people who have leveraged how it has worked for them. You'll find both tales of woe as well as tales of abundance.
Go with your gut. Leveraging is risky, no doubt about it. If you are the sort to wake up in the middle of the night in a cold sweat because you're worried about your debt, then you are not a good leverage candidate. You may miss out on some superb returns, but at least you will have your health and a stress-free investment plan.

This article is from Nora Dunn of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: