Financing options give us leverage in real estate. This can be especially helpful if we want to jump-start or grow your real estate portfolios. The key to using leverage is to ensure you have enough capital to cover your payments and manage it responsibly.
Let’s review some essentials to help you understand leverage and how to use it in real estate investing.
You’ll also find more information in my best-selling book, Retire Rich With Rentals: How to Enjoy Ongoing Cash Flow So You Don’t Have to Work Forever.
What is Leverage?
Leverage is a physics term that refers to the ability to use something to move an object that would otherwise be too heavy.
In my book Retire Rich with Rentals, I use a car jack as a great example to explain leverage. “There’s no way you could lift a car with your bare hands. By placing a jack in the right spot and using the force of leverage, however, you can easily pick up a car of any size.”
What is Financial Leverage?
Financial leverage works the same way. In finance, leverage (sometimes called “gearing” in the United Kingdom and Australia) is a general term for any technique to multiply gains and potential losses. Most often, it involves buying an asset using borrowed funds, with the belief that the income from the asset will be more than the cost of borrowing.
When comparing leverage and financial leverage, the difference is that your leverage is using other people’s money (OPM). You can use someone else’s money to supplement what you have to buy a home.
What is Leverage in Real Estate
Leverage uses borrowed capital or debt to increase the potential return on an investment.
In real estate, the most common way to leverage your investment is with your own money or through a mortgage.
Leverage works to your advantage when real estate values rise but can also lead to losses if values decline.
The Best Conditions for Leverage
Using leverage in real estate investing works best when property values and rents increase. If values and rents are slow or declining, the advantages of using leverage can evaporate quickly, with loan payments increasing your carrying cost for the property.
For leveraged investors, there are two essential practices to achieve optimal success.
- Perform a comprehensive due diligence
- Develop a smart investment strategy
Leveraging Real Estate Investments with Mortgages
There are so many different ways to get financing to buy an investment property. The most common form of funding of includes conventional fixed-rate or adjustable-rate loans. The difference between fixed-rate and adjustable-rate loans is pretty simple.
Fixed-Rate Loans
A fixed-rate loan has the same interest rate for the life of the loan. If you choose to borrow from a mortgage company, Kathy Fettke suggests getting a 30-year fixed-rate loan. With this loan type, your interest rate, and therefore your payment amount, never change, regardless of what is happening in the market.
For example, if your loan payments are $500 per month today, they will stay $500 for the life of the loan.
Because the loan’s term is so long, the monthly payments will be less than those of a shorter-term loan, which helps with cash flow.
“Small loan payments, coupled with a predictable rate and the ability to refinance later, are just a few of the things that make a fixed-rate loan so great. The one downside is that fixed-rate loans tend to have a slightly higher interest rate than the alternatives. Since the rate will never change, the lender is going to want to cover any losses they might experience when rates go up. ” [Retire Rich with Rentals]
Adjustable-Rate Mortgage or Loan
An adjustable-rate mortgage (ARM) is a loan whose interest rate is adjusted periodically to reflect market conditions. The interest in an ARM is directly tied to a specific index. Generally speaking, ARMs tend to go up. While there is a possibility your interest rate may go down, this typically happens as a result of a real estate market dip.
The good news is, initial interest rates are usually lower on an ARM than a fixed-rate loan. If you are not able to get a fixed-rate loan for less than 8.5 percent, an adjustable-rate loan may be a good option, suggests Fettke. After a few years, you may be able to refinance your loan and get a better interest rate on a fixed-rate mortgage.
ARMs are also a great choice if you plan to sell your property within the loan’s timeframe, typically 2, 3, or 5-year terms.
Why We Love Leverage
Next, we will show you exactly why we love leverage in real estate using the following example:
- Joe uses $100,000 to buy gold = $100,000 value.
- Mary uses $100,000 to buy stocks on margin = $200,000 value.
- Pat uses $100,000 as a 20% down payment to buy property = $500,000 value.
15 Years Later…
Let’s assume a 5 percent annual growth. Remember, this is a huge assumption as it could be 10 percent annual growth one year or 0 percent the next. However, for our example, we will assume 5 percent annual growth:
- Joe’s gold is worth $207,000 = $107,000 profit.
- Mary’s stock is worth $415,000. After paying back the $100k margin and $100k capital = $215,000 profit.
- Pat’s property is worth $1M, a $400k loan paid down to $200k = $700,000 profit.
Pat Gets More Bonuses
- The properties were rented, producing income after expenses = cash flow.
- 10% of $100,000 is an additional $150,000 in 15 years.
- If Pat put all of that cash flow toward paying off the loan, the entire property would be paid off in 15 years.
- $1M equity, plus $120,000 rental income for life.
- Plus, tax deductions.
As illustrated by our example, Pat is the clear winner when it comes to return on investment by leveraging real estate to build wealth.
Understanding how to use leverage in real estate isn’t just for seasoned investors. Financing a property can be a sound investment strategy. Holding onto your leveraged property long-term may produce excellent returns and monthly cash flow as well.
How RealWealth Can Help
At RealWealth®, we provide our members with free real estate investing education, helping them learn how to use leverage in real estate. We also offer support from seasoned real estate investment counselors and connect them with lenders and turnkey property teams that sell professionally managed single-family and multi-family investment properties in the top markets nationwide. Membership to RealWealth is 100% free, yes, free. If you are ready to build your portfolio, join RealWealth today!
