By Scott Melbrod
There is a great quote by the famous mathematician and inventor Archimedes that goes:
“Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”
In this quote Archimedes was talking about leverage in the physical sense; through the use of tools like levers and fulcrums, you can lift a lot more than if you were to pick something up with your bare hands. But this concept of leverage can also be applied to finance, and it is especially useful during inflationary times.
The significant rise of inflation over the past several months has caused many to worry about the long-term effect on their purchasing power, making it more important than ever to protect your finances through the proper use of financial leverage. Here are some tips to help you get started today.
Be the “Borrower”
The best way to leverage your financial position in inflationary times is to be the “borrower” by owning assets, not debt. This means you should look for financial products that allow you to borrow money in order to purchase an asset (e.g., mortgages or other real estate loans and even Securities-Backed Lines of Credit against your stock portfolio) as opposed to those in which you lend money to others (e.g., bonds).
There are several reasons to consider borrowing instead of lending, including:
A Dollar Today Is Worth More Than a Dollar Tomorrow
Because inflation causes the value of your money to decline over time, funds borrowed today will be paid back with money that is worth less than it was when it was originally borrowed. For instance, if you were to borrow $1 million today with a 4% inflation rate, in 10 years it would only have the purchasing power of $675,564. (1) This can make borrowing particularly appealing during an inflationary environment, especially if the assets you purchase with the borrowed funds appreciate at a rate with or higher than inflation. Also, if your wages rise with the rise in prices, you will have more money in your paycheck that can be put toward paying off your loan quicker, resulting in less interest paid to the lender over the life of the loan.
Real Interest Rate Could Be Negative
When you borrow money, you are borrowing based on nominal interest rates. This is the interest rate listed in the loan details and it doesn’t account for inflation. The real interest rate, on the other hand, does account for inflation, and depending on how high inflation rises, the real interest rate on your loan could actually be negative.
Here’s how it works. Right now, the national average mortgage rate for a 30-year fixed mortgage is 3.24% (2) and the inflation rate for 2021 was 6.8%. (3) This means the nominal rate is 3.24%, but the real interest rate is -3.56%! (4) In this case, the lender is actually paying you to borrow their money! It is the ultimate form of leverage.
You can further leverage your position by using the borrowed funds to buy real estate. The income earned from that property (bought with borrowed money) is tax-deferred via the depreciation of the property. By doing this, you can set yourself up for a highly leveraged stream of income that is both inflation-protected and tax-advantaged, which helps to maintain your purchasing power over time.
Don’t believe me? Believe the wise words of one of the greatest real estate investors of our generation, Sam Zell of Equity Group Investments. He said in his book Am I Being Too Subtle?: “We believed the real money in real estate came from borrowing long-term, fixed-rate debt in an inflationary scenario that ultimately depreciated the value of the loan and increased the position of the borrower.”
Collecting Interest Income Is Tax-Inefficient
Conversely, if you were to lend money to a company in the form of buying a corporate bond, you are effectively de-leveraging your financial position and creating tax inefficiencies in your portfolio. This is because most bonds pay coupon payments which are received as interest income and are taxable in the year received. When compared to the tax-deferred stream of income created by borrowing funds to purchase real estate, it doesn’t make logical sense to choose lending (bonds) over borrowing (to purchase real estate).
To top it off, the inflationary environment creates the opposite effect for lenders as it does for borrowers. Because inflation causes money to decrease in value over time, the coupon payments you receive from a corporation will be worth less money each time they are paid as opposed to how much they were worth when you first purchased the bond. The real interest rate is negative, and you are effectively paying the corporation to borrow money from you!
Are You Making the Most of Your Financial Leverage?
Many people find high inflation environments to be scary and stressful, especially as they read headline after headline about how their purchasing power is all but gone. At Taxable Wealth, we believe there is more to it than that. A properly leveraged financial position can be used to make the most out of an otherwise anxiety-inducing situation.
To learn more about how you can use inflation to your advantage, call my office at (858) 221-7521, email me at [email protected], or schedule a call using my online calendar to get started today.
Scott Melbrod is the founder and CEO of Taxable Wealth, an independent wealth management firm in San Diego, CA. Working with a wide array of clients and focusing on real estate professionals, investors, and business owners, his mission is to provide impactful and targeted financial advice at a transparent cost to people who want to reduce their tax burden and minimize investment and insurance-related fees that eat away at their savings. With more than 15 years of industry experience, Scott uses his knowledge to develop solutions and structured, tailored financial plans designed to guide his clients toward financial freedom.
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