If you’re in the real estate investing business, you’ll benefit greatly by learning what leverage is, and how you can use it as a tool to accelerate wealth building. When you can really understand the power of leverage, and use it often, you’ll be unstoppable.
What is leverage?
Leverage in real estate is borrowing money to maximize your potential rate of return on your investment. You leverage other people’s money to maximize your chances to get even more properties. It’s using financing to put money in your pocket, allowing you to be more in charge of your properties with little cash coming out of your pocket.
Isn’t leverage debt?
Many people confuse financing and debt. The first thing you must understand is that there are different types of debt. There’s consumer debt, like money owed on a credit card, and that’s not necessarily the kind of debt you want. It’s high interest debt, or a liability, that won’t make you money.
On the other hand, using financing to purchase a rental property can help you MAKE money, without using your own money. You’re using the financing to purchase an asset, not a liability.
How can leverage help in real estate?
When it comes to your investment properties, you want to maximize your profit margin. Let’s look at an example.
Let’s say you have $100,000 cash and you’re interested in purchasing rental properties. You have some choices. You can either:
- Purchase a home that costs $100,000 with your cash. In doing so, you’ll have 0% leverage.
- Purchase a home that costs $200,000. Use your $100,000 in cash, AND finance the other $100,000 through a mortgage loan. This means you’ve paid 50% in cash and financed 50%, so you’ll have 50% leverage.
- Purchase a $300,000 home. Use your $100,000 cash and then finance the remaining $200,000. This means you have 75% leverage.
Now, let’s look at the numbers for all three scenarios, assuming you had a 7% property value increase this year.
- The $100,000 home: At 7% increase, the property value is now $107,000. Your net gain is $7,000.
- The $200,000 home: At 7% increase, the property value is now $214,000. Your net gain is $14,000.
- The $300,000 home: At 7% increase, the property value is now $321,000. Your net gain is $21,000.
As you can see, the larger the purchase price, the larger the net gain.
Options for financing
There are various options for financing a mortgage loan for your rental property. Let’s look at two traditional methods:
- Home mortgage
A home mortgage is typically the way many people go to finance their mortgage loan. This is probably the type of mortgage you took out on your primary residence. Keep in mind that financing rental properties works a bit different than your primary residence. You may have to put 20% as a down payment and the interest rate may be higher. If you have equity in your other rental properties, you can use your rental income to qualify for a new loan.
- Home equity line of credit
Many investors use a line of credit to purchase new rental properties. You can use the equity that you have in your own home to secure a new loan. This type of loan, oftentimes called the HELOC, is a secure line of credit borrowed against the equity in your home.
There are more ways to do this and I discuss them in detail in some of my courses, so if you are interested you should look to those for the best way to go about rental properties.
When it comes to maximizing your profit margin, using leverage is a wonderful way to get the most bang for the buck. By borrowing capital toward your investment, and anticipating profit to be higher than the interest, you are making more money than if you used cash.
That, my friends, is what you want!