The wealthiest Americans borrow against their assets to multiply their wealth, often using the borrowed funds to make new investments or to cover expenses without selling assets (and triggering capital gains taxes).
Wealthy Americans treat their personal assets like a business would treat its balance sheet. They seek to efficiently maximize income and minimize costs by using all the resources at their disposal, including their assets from which they can take out loans. This can be a highly effective way to build wealth.
Thinking like a business owner
If we were to think of this concept as if it were a business, we can get an idea of how it works through the following example:
- A manufacturing company wants to expand their production capacity of widgets by building a new factory. To build the factory the company must raise capital.
- To do so, the company would not sell their existing manufacturing facilities, as it does not make sense to sell a pre-existing asset just to build another asset in its place. Rather, the company would likely borrow funds (take out debt) to build the new factory.
- The company could take out a loan that is secured against their existing assets (such as inventory, factories, equipment, etc.) and use that to build the new factory. The income generated by the new factory would be used to pay down the debt at a later date.
The wealthy apply the same approach when managing their personal finances. They borrow at low rates (secured against their assets) and then use the funds to make more money. If a wealthy individual borrowed against their stock portfolio at an interest rate of 5% and took the proceeds and invested it for an annual return of 10%, they would net a profit. The money gained from investment returns would be enough to pay down the debt and still have profits leftover. They can repeat this again and again, creating a multiplier effect for their wealth.
Example:
We can see above that, just by leveraging their existing assets (borrowing against them to invest) an individual can create substantive returns and magnify their wealth.
What assets can You borrow from?
The wealthiest people can borrow against numerous different asset classes such as stocks, real estate, artwork, and more.
Lenders often provide secured loans up to an amount up to 100% of the underlying asset value. This threshold is known as the loan-to-value ratio (“LTV”). The LTV will depend on the lender, the borrower’s credit history and financial status, as well as the safety of the underlying asset.
For example, a wealthy individual may have a stock portfolio worth $1 million, and lender may offer funds up to $500,000 (a 50% LTV ratio) due to the volatile nature of the stock portfolio. Stock prices can fluctuate up and down, so a lender typically will not provide a high LTV ratio. If instead the individual wanted to borrow against his portfolio of cryptocurrency assets, the LTV would likely be even lower as crypto prices are more volatile than stock prices.
The volatility of the underlying asset is critical in determining the appropriate LTV ratio of the loan. This is what makes real estate such a good asset to borrow against, as real estate prices tend to be highly stable compared to other assets. This includes residential real estate such as one’s primary residence.
Borrowing against Your home
Just like the wealthiest individuals, the typical homeowner can also borrow against their primary residence via a home equity loan (“HELOAN”) or a home equity line of credit (“HELOC”). As homeowners build up equity in their homes (see blog post 1) they have a strong and stable asset from which they can borrow. And typically, due to the stable nature of home prices, the LTV on HELOANs and HELOCs is quite high (up to 85% to 100%).
The homeowner can use the funds for basically anything such as home renovations, tuition, vacation, debt consolidation, and more. The funds must be repaid to the lender (usually a bank, credit union, or other mortgage lender) over time, but generally HELOANs and HELOCs have long-term and/or flexible repayment structures that help minimize the monthly payment amounts. This will be discussed more in a future blog post.
Further, one of the best features of borrowing against home equity is the interest rate is typically far lower than unsecured debt (such as a credit card or personal loan), as the lender has security from the underlying asset should the borrower stop making payments.
Although there is risk associated with HELOANs and HELOCs, as the home is used as collateral and could be liquidated should the borrower stop paying, the low interest rates and flexible payment structures typically allow for a very favorable outcome for the borrower.
