Leverage can turn an ordinary income and savings into real wealth.
Today’s topic is leverage.
This is one of my favorite financial topics and here’s why: Leverage can turn an ordinary income and savings into real wealth. It’s the key behind the fortunes of many millionaires.
So what is leverage and how can you use it to take control of your financial future? Leverage means using a lever. It’s the power to lift something really heavy with a relatively small effort. When it comes to money, it means using borrowed money and a relatively small initial investment to control a much larger asset.
Leveraging Your Real Estate Investment
So what types of investments allow you to use leverage? Well, real estate is one of them. It’s possible to invest in a home using a very high degree of leverage or OPM: other people’s money. This means that, over the long term, you get the benefit of appreciation on the full value of the house, but most of the money used to buy it is the lender’s not yours. This is one of the biggest benefits of investing in real estate. For short term investors, however, it’s also one of the biggest risks.
Although home price appreciation has slowed(1) nationally, over the long term, real estate has appreciated about 5% to 6% per year on average in the U.S. Now this return may not sound like anything to write home about, but the power of leverage can really magnify it.
Let’s look at a simple example: Imagine you buy a house for $100,000 and put $20,000 down (that’s 5:1 leverage). If the house appreciates 5% in the first year, you’ve earned $5,000 on your $20,000 investment from the appreciation—that’s a 25% return (not accounting for closing costs). It’s an impressive return. If you put only $10,000 down (that is, if you use 10:1 leverage) instead, your return from the appreciation doubles to 50%. Now, that’s an amazing return! This example is very simple to illustrate the point. It doesn’t account for net rental income if the house were rented. Assuming the house were rented and generated a positive cash flow, the returns would be even better.
Simply put, leverage can create millionaire returns. With leverage, you can create wealth much more quickly than you could if you paid all cash for a property. If you bought the same $100,000 house for all cash, your return, based solely on that 5% appreciation, would be, of course, 5%. By putting 10% down, instead, the return is boosted 10 times to 50%.
In the U.S., it’s not unusual to put as little as 10% down with the lender financing the remaining 90%, even on a house purchased as an investment. With stocks, the highest leverage you can get is typically 50%, which means you can buy stocks at half their price with the brokerage house supplying the rest of the funds.
Avoid Margin Risk Through Real Estate
Using borrowed money to purchase stocks is called “buying on margin”. But you got to be really careful! It can be very risky! With stocks, you can get a “margin call” if the stock falls below a certain amount. A margin call means the brokerage house can demand that you deposit more money or securities into your account to cover a specified amount of the cost of the stocks bought with borrowed money. A margin call can force you to sell a stock at a very bad time!
With real estate, there is no margin call. If the value drops for a period, even to an amount lower than the balance on the mortgage, the lender doesn’t “call” the loan and expect you to suddenly pay it back. This is a good thing.
The Risks of Leveraging Real Estate
Using leverage to purchase real estate can magnify your returns, but it’s really important to remember that it can magnify losses as well. If you put 10% down on a house and the house drops 10% in value, on paper, you’ve lost your entire down payment. And when you factor in, say, 6% in realtor commissions, a drop of only 4% would erase your down payment if you were to sell. But, if you hold for the long term, the downside risk of using leverage when buying real estate is reduced a lot, since U.S. real estate has appreciated over the long term and outpaced inflation.
Now, Money Girl wishes she had known a little more about the power of leverage when she bought her first house. I put 20% down. Had I put 10% down instead, my monthly payments would have been higher, but I would have had the remaining 10% cash to cover that incremental additional payment for many years with money left over to invest in something else.
The power of leverage is the reason that real estate, wisely purchased and held for the long term, can be a powerful strategy to build wealth.
This week, we have a book give-away. Here’s how it works: If you sent me an email or posted to the blog in the Money Girl section of quickanddirtytips.com, you’re automatically entered in the book give-away. This week, the winner is… Amber P. Congratulations, Amber! Please check your email for instructions. You’ve won Investing in Real Estate by Andrew McLean and Gary Eldred, an excellent book on real estate investing with a great explanation of the concept of leverage.
Cha-ching! That's all for now, courtesy of Money Girl, your guide to a richer life.
If you have a question or comment, email it to email@example.com. Thanks for listening!
(1) U.S. home prices increased 0.86% in the third quarter of 2006 (the most recent quarter for which data is available) according to the Office of Federal Housing Enterprise Oversight (OFHEO).
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