It may be somewhat counter-intuitive, but many well to do folks carry debt. Even the world’s largest corporations carry debt. There are a multitude of reasons that these people do so, and one of these is called leverage.
The most prevalent form of leverage in the US is a home purchase. A home is a great way to store value, but most people don’t have enough cash to purchase one directly. In order to do so, they take money from a bank as a loan called a mortgage. This allows folks to purchase a home for somewhere between 3% and 20% of the total cost of the house. The ratio of the total cost to the money that you put in is called the leverage ratio. So for 20% down, that ratio would be 100% / 20% = 5. This is most commonly stated as 5x, or a 5 times leverage ratio.
Let’s see why this leverage ratio is important. If we buy a house for $100,000 with 20% down, we will have paid $20,000. This will give us a leverage ratio of 5x. If the house value increases by 3% to $103,000 and we sell it, we will pocket $3,000 in profit (ignoring transactional costs and loan interest). This profit, stated as a percentage of our down payment, is $3,000 / $20,000 = 15%. Notice how the 15% return is 5 times the 3% return of the actual house. This is directly related to the fact that we purchased the property with a 5x leverage ratio.
Of course, the reverse is also true. When the house loses value, the homeowner will experience the loss at a rate 5 times what the house experiences. So in this example, a total loss would be $100,000 or 500% of the $20,000 the homeowner paid.
So how do we use this to pay for a really large expense like college? Let’s say college costs $25,000 per year for 4 years. Let’s also say that houses can be purchased and rented out for a 5% profit per year. Then in this scenario, a house will have to be worth $25,000 / 5% = $500,000 to produce $25,000 per year to pay for college. We can then use leverage provided by a bank to purchase the house for 25% down, or $100,000. We still need $100,000 to pay for our kid’s college, but after 4 years, we will have a rental house producing $25,000 per year and a kid with a college degree instead of just a kid with a college degree. Additionally, the $100,000 will still be stored in the house’s value. This all works out because the leverage ratio of 4x in the example translates the 5% return of the house to a 20% return.
If you purchased a house at the same time you started a family and are then trying to send your kid to college 18 years later, there will probably be a significant amount of value stored in the home. You can unlock this stored value without selling your home with a home equity line of credit (or HELOC). If you use this HELOC as the down pay for the scenario above, you will have essentially paid for your kid’s college with no money out of your pocket.
This general line of thinking is called asset-liability matching. We are matching an asset (the rental house) to pay for a liability (cost of sending kid to college). By using leverage, we are able to greatly reduce the out of pocket cost of sending our kid to college. This is a very simple example and inherently carries various types of risk that are greatly magnified by the leverage. Every person’s situation is different and this may or may not be a good decision for you. Please consult with a professional before attempting anything like this.
There are many ways to do this and getting assets and liabilities to match sometimes requires a great deal of creativity and maneuvering. If you are really good at asset-liability matching, life insurance companies and banks pay top dollar for this type of talent.