The power of leverage: How to make a dollar out of 15 cents
Need extra money?
What is leverage exactly?
Leverage
Simply put, leverage is the use of borrowed money to create higher potential returns for an investor.
There are many different forms of leverage out in the investment world such as margin, options, and futures, but I don't want to talk about those. While they each offer a way to increase your personal returns in the stock market, but you have to be very knowledgeable about the stock market and how to use this leverage in order to get your desired returns. On top of that, these are all fairly risky forms of leverage if you don't know what you are doing. you could end up losing your life savings with one mistake or even just getting unlucky.
Facts:
Fact #1: Leverage magnifies both GAINS and LOSSES... It is risky, but sometimes the risk is worth the reward.
Fact #2: If you are uncomfortable with Fact #1, stay away from leveraged investing. Especially be cautious using margin accounts, options, and futures investing (in fact, I would probably feel better saying that you should stay away from all three of these options unless you have a background in finance or investing).
Fact #3: Disregard Fact #2 when it comes to real estate.
Anyway, know that you know the facts, the type of leverage I want to talk about is centered around mortgages...
While some people (even reknowned personal finance author's like Dave Ramsey) encourage people to stay away from debt at all costs, I believe that debt is a useful tool that can be used to leverage your investment in real estate. It doesn't matter if you are acquiring the debt for your personal home or for rental units. Using leverage when you purchase real estate can supercharge your investment returns.
Leverage
3 examples of using leverage
Example #1: Using leverage with your own home
You have saved and saved and saved some more and are finally ready to buy your first home. You know find yourself with a couple of different options to purchase the house. You plan to stay in the home for 10 years and then sell it for a larger home regardless of which option you choose to purchase the home.
Option A: You have enough money to buy the house for the full sticker price of $200,000, so you pay the full amount.
Option B: You put down 50% and finance the remain $100,000 at a rate of 4% over a 30 year term.
Option C: You put down 10% and finance the remaining $180,000 at a rate of 5% over a 30 year term.
Assumptions: It is hard to speculate on the real estate market from year to year because in my opionion, real estate is local, and also because it is constantly fluctuating. This is especially apparent when you consider the huge losses incurred over the last several years starting in 2006 and still holding into 2012. However, for the purpose of this scenario, we are going to assume that real estate will keep pace with inflation over the next 10 years. Since the government started tracking inflation in 1913, the average annual inflation rate is 3.43%. I believe this is a low estimate on what we can expect in real estate returns over the next 10 years, but I think it is a good benchmark, that most people won't argue with too much. We will also assume that the stock market will average 8% during this time (although historically most experts will agree is around 11%). Any money not spent on the initial purchase of the home will be deposited into an index fund tracking the S&P). Again, I am just using this rate as a benchmark which I think that most people will agree is reasonable.
So, based on the assumptions what kind of return will be made for each of the options listed above
Option B: Mortgage Data
Yearly Amortization Schedule
| ||||
|---|---|---|---|---|
Payments
| Yearly Total
| Principal Paid
| Interest Paid
| Balance
|
Year 1 (1-12)
| $5,728.98
| $1,761.00
| $3,968.00
| $98,238.96
|
Year 2 (13-24)
| $5,728.98
| $1,833.00
| $3,896.00
| $96,406.18
|
Year 3 (25-36)
| $5,728.98
| $1,907.00
| $3,822.00
| $94,498.73
|
Year 4 (37-48)
| $5,728.98
| $1,985.00
| $3,744.00
| $92,513.56
|
Year 5 (49-60)
| $5,728.98
| $2,066.00
| $3,663.00
| $90,447.51
|
Year 6 (61-72)
| $5,728.98
| $2,150.00
| $3,579.00
| $88,297.29
|
Year 7 (73-84)
| $5,728.98
| $2,238.00
| $3,491.00
| $86,059.47
|
Year 8 (85-96)
| $5,728.98
| $2,329.00
| $3,400.00
| $83,730.48
|
Year 9 (97-108)
| $5,728.98
| $2,424.00
| $3,305.00
| $81,306.59
|
Year 10 (109-120)
| $5,728.98
| $2,523.00
| $3,206.00
| $78,783.96
|
Option C: Mortgage Data
Yearly Amortization Schedule
| ||||
|---|---|---|---|---|
Payments
| Yearly Total
| Principal Paid
| Interest Paid
| Balance
|
Year 1 (1-12)
| $11,595.35
| $2,656.00
| $8,940.00
| $177,344.34
|
Year 2 (13-24)
| $11,595.35
| $2,792.00
| $8,804.00
| $174,552.82
|
Year 3 (25-36)
| $11,595.35
| $2,934.00
| $8,661.00
| $171,618.47
|
Year 4 (37-48)
| $11,595.35
| $3,084.00
| $8,511.00
| $168,534.00
|
Year 5 (49-60)
| $11,595.35
| $3,242.00
| $8,353.00
| $165,291.72
|
Year 6 (61-72)
| $11,595.35
| $3,408.00
| $8,187.00
| $161,883.56
|
Year 7 (73-84)
| $11,595.35
| $3,583.00
| $8,013.00
| $158,301.03
|
Year 8 (85-96)
| $11,595.35
| $3,766.00
| $7,830.00
| $154,535.21
|
Year 9 (97-108)
| $11,595.35
| $3,958.00
| $7,637.00
| $150,576.72
|
Year 10 (109-120)
| $11,595.35
| $4,161.00
| $7,434.00
| $146,415.72
|
Results
Results:
Option A:
Home value = $280,217.49
Balance Due on Home: $0
Interest Paid on Home: $0
Stock Market Return: $0
Total Return = $80,217.49
Total Return % = 40.1% (or 4.01% annually)
Option B:
Home Value = $280,217.49
Balance Due on Home: $78,783.96
Interest Paid on Home: $36,074
Stock Market Return: $215,892.50
Total Return: $381,251.54 ((280,217.49-$78,783.96)-$36,074)+ $215,892.50)
Total Return %: 191% (or 19.1% annually)
Option C:
Home Value = $280,217.49.
Balance Due on Home: $146,415.72
Interest Paid on Home: $82,370.00
Stock Market Return: $388,606.50
Total Return: $440,038.27 (($280,217.49 - $146,415.72) - $82,370) + $388,606.50)
Total Return %: 220% (or 22% annually)
As you can see from the example above, using leverage in real estate purchasing is a very useful tool. While this does add some risk, it also magnifies the potential returns. I think that debt, is not necessarily a bad thing, as long as you can manage it properly.
I hope you learned something here today, and that you use the information wisely.
Thank you.
