The Powerful Effects of Leverage – How Ordinary People Become Rich
Leverage, in simplest terms, is applying your output in an intelligent way to gain the greatest advantage. Leverage is how ordinary people lift boulders with a pull of a lever, drive cars with a minor push of a pedal, and create multi-billion dollar businesses with an idea and education. Simply put, it’s how ordinary people, like you and me, can become rich!
“Give me a place to stand and with a lever I will move the whole world.” – Archimedes
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In real estate, leverage is using a lot of other people’s money and a little (or none) of your own to purchase properties. Just as a carpenter leverages his talents and physical abilities through the use of tools such as hammers and saws, a real estate investor uses tools such as banks, advice from other investors, and a financial education. One of the myths of real estate is that you “need a lot of money to invest” or “investing is only for the rich.” That couldn’t be further from the truth. That $100K fixer upper or buy-and-hold investment doesn’t necessarily require you to pony up 100 stacks to purchase it. Now that I have your attention, keep reading!
Leverage is how ordinary people, like you and me, become rich in real estate! Click To Tweet How do you come up with those fat stacks of cash to lock that property down? A reputable bank will be happy to work with you to acquire a mortgage for that property at 25%, 20%, or maybe even 15% down. This greatly depends on whether or not you have a commercial or residential loan. Check with your banker to see which mortgage is right for you. “If someone’s buying a home for investment purposes, it’s truly considered a commercial loan,” said Marcia Correll, a commercial lending expert in Hiawatha, Iowa who has been in the industry for over 30 years. “Generally when someone’s buying a home for themselves, they can go up to a 30 year fixed rate loan,” continues Marcia. “When they’re buying it on a commercial basis, generally, the longest that the rate will be fixed for is a 5 year period because most of those loans are held in-house at the bank because they are in a commercial portfolio.”
If you are an experienced investor who already has a few properties under your belt, you could apply leverage even further. “Sometimes, we can utilize equity that they have in other assets in order to get that down payment. It is possible, but then again it depends on what they’re personal balance sheet looks like and what we can utilize for that 25% cash down payment.” said Marcia.
Leverage: A 20% Down Example
A key benefit of leverage is that $20-25K in the bank can be converted to a $100K investment property that also earns you Income, Depreciation, Equity, and Appreciation benefits against $100K, not $20-25K. Since we believe in searching for properties at least 15% below market value, your purchase could cost even less. Do all of those terms mentioned above sound familiar? All of that IDEAL Investing has been building up to this very moment. This, my friends, is what we call leverage. $20-25K of your money just picked up a cool 100 grand of investing and purchasing power. See the table below for an example:
Table 1: 30 Year Projection of a $100,000 Home, Purchased for $85,000, at 20% Down
All five benefits of IDEAL Investing can be shown when evaluating a property’s financial performance. We outline those in Table 1. Leverage, in this example, is the out of pocket investment of $20,000 which originates from a $17,000 down payment (20% of an $85,000 purchase), plus $3,000 in closing costs. With the help of borrowed money, as long as you ensure that your net income from the rent exceeds your mortgage payment, you’ll be investing and cash flowing right away. No need to wait many years (or never) to scrimp and save for that entire $100K. Saving that kind of money (without busting the proverbial piggy bank in the process) is very difficult for most of us.
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Buy, Live, Move Out, and Rent: 3.5% Down Example
3.5% down? Really? No bank is going to let you buy investment properties with only 3.5% down. Well, consider this. You buy a home that you are going to occupy as an owner (or perhaps you are already living in a home that required very little money down.) Let’s say you move to another home and rent your property out. If you had purchased this property for $85,000 with a Federal Housing Administration (FHA) loan at a 3.5% down payment, you’d only have to put $2,975 down. Include the $3,000 closing costs (if the seller hadn’t already baked those into the purchase price) and you have an out of pocket investment of only $5,975. Some people actually make a living investing this way. They live in a house for a couple years, move out, rent it, live in another, and repeat the process. This is “buy and live” rather than “buy and hold”. See the table below for the incredible ROI you can get with your cash after 30 years when the down payment is so low.See what a $100,000 property can get you with only 3.5% down! A 30-year projection. Click To Tweet
The Beauty of Leverage
The secret sauce to leverage, besides lowering the barrier to entry, is control. Real estate is one of the few investments where you can have 100% control of an investment with only 25% or less equity ownership! Imagine going to a company, buying 20-25% of it, and then telling them you want to be the sole decision maker of the company. They would run you out of there faster than three shakes of a lamb’s tail. Don’t let the door smack your oversized ego on the way out! With real estate, you could even be a 0% equity owner and still have all of the control…that is what they call buying real estate with “no money down,” read this great post about little to no money down investments. Sure, with lending you are indebted to the bank, private money lender, or investor you’ve made this mortgage arrangement with, but you owe nothing to them besides their original money, a little interest, and a guarantee of insurance on the property. You won’t see the bank coming by to tell you how to manage your real estate investment!
Risks of Using Leverage
It’s important to note that leverage increases investment risk. When you use debt to control large assets, the benefits are multiplied when the property value increases or when you receive income from the tenant. The reverse can happen if the property loses value or goes vacant for long periods of time. Now, you have a second mortgage that has to be paid every month, or you can kiss that house goodbye. Make sure to keep at least 6 months in cash reserves for your first property, or the first few properties. The best way to do this is to cover 6 months of rent at $6,600 in our example. That may seem high (you are thinking you only have $550/month of mortgage payments, escrow for insurance and taxes included), but consider the fact that you now have to cover some basic utilities and plan for any major repairs that could occur on the property. Build a cash reserve rather than a house of cards that can come crumbling down with the first large emergency!
Go Boldly Forward!
Now that you know all of the five benefits of IDEAL Investing and how they work for you, make sure to continue your education and start finding that property. Follow our Investment Purchase Process to go through each step and find your “IDEAL” property! Put this IDEAL Investing tip, along with the other four, into your real estate investing arsenal and get ready to open fire.
Where to go from here?
10 Surprisingly Simple Steps to Buying a Rental Property – Here’s a quick overview of all of the steps you need to take to get from zero to ONE on your real estate investing journey or build your portfolio even more. Inside of this blog post, you will find links that allow you to deep dive into three core phases of the investment process: Get Ready, Get Set, and GO!
There is never a better time than the present to start investing. If you don’t start now, you may never end up doing so and you’ll end up on “Someday Isle.” As lifestyle designer, author, and serial entrepreneur Tim Ferriss says, “The stars will never align and the traffic lights of life will never all be green at the same time.” Stick with our team here at AssetRover and let us guide you in your real estate pursuits and help you fulfill your investment dreams!
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Before you leave:Don't forget to check out our free rental property calculator. This will be a valuable tool in your arsenal as you analyze your existing or potential rental properties.
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