You are about to learn a powerful secret in this article, one that you may have never fully understood but have probably utilized in the past. It revolves around the concept of using debt to increase the return on your investments through leverage.
Any time that you buy a house with only a down payment, you are engaging in this miracle act of leverage, which turns out to be the almost magical way to make potentially significant amounts of money.
The Definition of Leverage
Leverage is properly defined as a method of multiplying gains and losses. Another way of saying this is that debt, when it is invested, actually multiplies returns. Borrowing money to purchase an investment proves to be an easy way to undertake leverage. Corporations and businesses engage in this type of activity all of the time.
Banks are a good example of this, as are insurance companies. Banks loan out their customers’ deposits using a leverage of ten to one commonly. This means that they are able to collect interest payments on $10 million, even if they only have $1 million of money in deposits. Insurance companies do the same thing in a different way. With the example of a $1 million cash position, they write insurance contracts whose claims would total $10 million or even $20 million. They get to collect premiums on all of these contracts, making their return much higher than if they only wrote $1 million worth of insurance contracts.
Use Leverage For Your Home Mortgage
Where you are concerned, this principle of leverage can also work to your advantage in using debt to increase the possible returns on your investments. A mortgage on a house is a primary example. If you buy a $200,000 house, then most likely you will be required to put down around ten to twenty percent, or $20,000 to $40,000, as a down payment.
Assume that your credit is really terrific and that you are able to borrow $180,000 from the bank, while only putting down $20,000. This means that you have received a leverage ratio that amounts to ten to one. Another way of saying this is that for every $20 of the house asset that you acquired, you have put in only two dollars of your own money, or equity.
In this example, should home prices start to rise, then you will make money, but not only the literal percentage increase of the underlying home prices themselves. Specifically, if home prices rise ten percent, then you have not only made ten percent in your investment. The home value increased from $200,000 to $220,000.
Since the money that you invested was only $20,000 in the first place, and the money that you owe to the bank is only $180,000, then you have actually increased your original investment from $20,000 to $40,000. This represents an impressive 100% gain in the value of your investment. This became possible through the miracle of leveraging your investment through debt.
Leverage Formulas
The formulas for figuring out the possible gains to be made through leverage are as follows: leverage ratio equals the asset value divided by the equity. Similarly, the return on investment equals the leverage ratio multiplied by the percent change. So with a $200,000 asset value in the house example, divided by $20,000 in equity money that you put in, you arrive at a ten times leverage ratio, or ten to one.
The return is then figured out by multiplying that ten leverage ratio times the ten percent change in the value of the house. This is how the one hundred percent is arrived at in the example. Or put another, simpler way, you controlled $10 for every single dollar that you put into the house investment. That gave you a ten times profit return on the investment.
Leverage Considerations
It is important to be really careful when employing leverage, so that you do not become a victim like so many others in the housing crises of the last few years. While this leverage can work tremendously to your advantage when prices are rising, it also cuts both ways when prices of the asset in question are falling. Should the $200,000 house fall ten percent instead of going up by that amount, then the full $20,000 investment that you made has disappeared, but only on paper.
This is why patience can be required in this kind of leveraged investing. The lending institution will not call you looking for more money when the value of the house that the mortgage is based on declines. Such losses, as with the gains, are only realized when you sell the property in question. This means that you are able to ride out a property depreciation and wait for the prices to recover and go back up, just as you can choose not to sell a house that has increased in value.
The Real Power of Leveraging Mortgages
By now you have seen the power that leverage has to offer you in your investments. You can begin to understand how people were capable of making small fortunes if they were able to buy multiple houses, rent them out to pay their underlying mortgages, and then later on sell them when the property prices had appreciated significantly. For example, someone who started with a hundred thousand dollar house that he or she only put ten thousand dollars in, then found a reliable tenant to make the monthly rent payments equal to the mortgage, was gaining in more than one way.
On the one hand, the person was leveraging their investment to the tune of ten to one leverage ratio, as discussed in the above examples. At the same time, the individual was gaining equity, or additional dollar ownership in the property with every payment made. Yet the money for these monthly mortgage payments was coming from the rent money paid in by the tenant.
On top of this, the owner of the house received special tax write offs on the mortgage interest paid to the bank. You can do this yourself to great effect, and over time, you might build up a portfolio of house properties for which you have only put ten to twenty percent of the purchase price into the houses. And it is all accomplished through the power of leverage.
How to Find a Funding Source to Leverage Your Mortgage
Now, to begin using the power of leverage to your advantage, you will first have to find someone to make you a loan, or mortgage, on your first house property. Traditionally, this is the purvey of banks or savings and loans institutions. Banks are a good place to start looking for home loans or mortgages, but they are not the only such place to find them.
One choice for a person who has built up a great amount of money in his or her 401K is to arrange a loan against the 401K. This is not the same thing as withdrawing the money from the plan. With a 401K loan, you will actually have to pay back the loan, over a set amount of payments, and with interest. The rate will be considerably lower than taking out credit card cash advances, though perhaps not as low as a mortgage.
Another source of money to buy a house with is from a finance company, such as ditech.com or GreenLightLoans.com. Companies like these offer thirty year home loans for as little as 4.5% APR, or annual percentage rate.
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