Leverage: Increasing Your Real Estate Net Worth

Investopedia. Posted: Sep 29, 2010

 

Leverage is the use of various financial instruments or borrowed capital to increase the potential return of an investment

Consider the common real estate purchase requirement of a 20% down payment – or $100,000 on a $500,000 asset. The buyer is essentially using a relatively small percentage of his or her own money to make the purchase, and the majority of the money is being provided by the lender. Real estate investors often refer to the remainder of the purchase price as “other people’s money,” since persons other than the borrower provided the money needed to make the purchase.

Assuming the property appreciates at 5% per year, the borrower’s net worth from this purchase would grow to $525,000 in just 12 months. Comparing this gain to the gain from an unleveraged purchase highlights that value of leverage. For example, the same borrower could have used the $100,000 to make an outright, paid-in-full purchase of a $100,000 property. Assuming the same 5% rate of appreciation, the buyer’s net worth from the purchase would have increased $5,000 over the course of 12 months versus $25,000 for the more expensive property. The $20,000 difference demonstrates the potential net worth increase provided through the employment of leverage.   Now, picture that 5% gain every year for 20 years. Over time, the use of leverage can have a significant, positive impact on your net worth.

The Dangers of Leverage
Just as leverage can work on your behalf, it can also work against you. Revisiting our earlier example, if you use a $100,000 down payment to purchase a $500,000 home, and real estate prices in your area decline for several years in a row, the leverage works in reverse. After year one, your $500,000 property could be worth $475,000 if it depreciates by 5%. A year after that, it could be worth $451,250 – a loss in equity of $48,750.

Under that same 5% price-decline scenario, if that $100,000 had been used for an all-cash purchase of a $100,000 home, the buyer would have lost just $5,000 the first year home prices fell.

1 Comment

  1. Comment by garthlyon

    Good information…thanks!

RSS feed for comments on this post.

Sorry, the comment form is closed at this time.