When buying an investment property, first you’ll need – you guessed it – money to invest. Whether you’re purchasing your primary residence or another investment property, you’ll likely need other people’s money to help you meet the total price of the house. Meet leverage.
Leverage helps you buy property and increase your net worth with a small amount of your own money. Even homeowners who aren’t active real estate investors are using leverage if they take out a mortgage. You might be surprised to learn that there are several places where you can source other people’s money to help you pay for your investment.
What is leverage?
Leverage is using financial instruments or borrowed capital to increase your investment potential. Leverage is a common real estate investment tool that, when used wisely, can maximize your profit potential.
Let’s say you want to buy a $300,000 house. You have $60,000 for the standard 20 percent down payment; a lender provides the remaining 80 percent of the purchase price. You are buying the home with a small amount of your own funds and the rest with someone else’s money. That’s leverage.
After one year, your $300,000 investment property appreciates 3 percent and is now worth $309,000. Even though you’ve largely purchased the property with the lender’s money, your asset is now worth $9,000 more.
Had you used your $60,0000 to make a $60,000 investment, assuming the same 3 percent rate of appreciation, you would only increase your asset’s worth by $1,800. Now expand that appreciation for five, 10, 20 years. The value of leverage is in this net worth differential.
How to find leverage
If you have good credit, you should be able to obtain financing for your investment property relatively easily. However, the lending company will treat your loan differently for your investment residence than your primary residence and likely charge a higher APR. Lending companies tend to view investment properties as riskier loans than permanent residences.
The best way to access leverage is to be prepared to contribute your own money for your down payment. Because lending companies are more wary of lending for investment properties, they may also want you to make a larger down payment than 20 percent.
As with any aspect of buying a property, always review and compare lending companies before making a decision. A big bank might have a different approach than a local bank. You may be able to build a partnership with whichever lending company you choose, making them part of your real estate investment team.
In some cases, you may be able to purchase a property with little or no money down. You may have investment partners who are purchasing some or all of the property. Sometimes a seller may be willing to finance some of the purchase price. Be careful though, there’s such a thing as being over-leveraged (more on that below).
Maximizing your leverage
When you’ve found your investment property and are ready to make an offer, negotiating better deals and financing will maximize your leverage and increase your profit margin. Don’t be afraid to negotiate with your bank; even a 0.5 percent interest rate reduction will help you. Work with your realtor to craft a competitive but low offer to begin negotiations with the seller. You are buying this investment property because you want to see a profitable return on your investment; make sure you are negotiating from a position of wanting to maximize your profit potential.
If you have an investment portfolio, you can use your other properties to maximize your leverage. Another example: you have the opportunity to buy an investment property, but don’t have the cash on hand at the moment. You can refinance another property, and use the money towards the down payment.
Risks of using leverage
As with any investment, investment homes don’t always appreciate in value. Using the same example above, your $300,000 property could depreciate 3 percent in one year, making it worth $291,000 and losing $9,000 in equity. That’s only a $1,800 loss for a $60,000 investment.
In a bad market, you could end up owing more money on the property than it is actually worth and eliminate your profits entirely. If rental prices decline, you may not be able to cover the cost of your mortgage. Regardless of the property’s worth, you still need to pay the principal and interest on the full value of your $240,000 loan.
With that in mind, you shouldn’t rely on appreciation to cover your costs. Cash flow is the most important factor in the success of your investment. If your rental income covers your mortgage and other costs, but the house doesn’t appreciate as quickly as you’d like, you’re still in good shape. If you’re relying on appreciation to cover low rent or other costs, you could be in trouble.
If the value and rental prices decrease drastically, you could end up defaulting on the property. If you were using the income from this property to pay for other properties in your portfolio, it could seriously hurt your portfolio and put your properties at risk of foreclosure.
While you theoretically could buy a property without investing any of your own money, it’s not a wise financial decision. Don’t just buy a property because you’ve found a good leverage opportunity. You need to rationally evaluate the property like you would if you were investing a lot of your own money by evaluating data about the home, neighborhood and market trends.
Leverage is one tool in your investment toolkit
When using leverage, you need to know how comfortable you are with debt. As you grow your portfolio, you’ll find the balance of how much you’re willing to invest of your own money versus how much debt you’re willing to have. Leverage is a great way to help you grow your investment portfolio when used wisely. If you’re a new investor, get comfortable with the concept early and you’ll have a long, fruitful road ahead of you.