Leverage is one of the big selling points where real estate investment is concerned. It makes sense why – it allows investors to use less of their own money to acquire valuable, income-generating assets. But, like all things, utilizing leverage comes with risks. While the advantages are significant, every investor must consider the pros and cons and decide how much to leverage.
Here’s the rundown:
The Pros of Utilizing Leverage
Balancing out risk
In layman’s terms, leverage is taking out a loan and securing it with a downpayment. Theoretically, while you could use $100,000 to buy a single property all-cash, you could also split that into five $20,000 downpayments to buy five properties.
Immediately, you get diversification. You’re not putting all of your eggs in one basket. Risk management is key to a successful investment portfolio, so leverage is a no-brainer!
Using equity to your advantage
Equity is the value of your asset minus its liabilities – such as the mortgage balance. As your equity grows through property improvements, appreciation, and the paying down of your mortgage, you can leverage it. A cash-out refinance can empower you to buy more properties or meet other timely financial goals. You can also negotiate for better loan terms.
Mortgage tax breaks
The mortgage interest you pay is tax deductible. The tax advantages are one of the many reasons people invest in real estate! While it might not seem like much, these deductions add up over the years. We encourage every investor to investigate and consult with a CPA to ensure they get the most out of their money come April 15th!
Greater buying power
Leverage allows you to buy better properties, period. Think about that $100,000 we mentioned. That’s a lot of money, but it won’t buy much house in today’s market. Leverage changes that. That $100,000, even split into multiple downpayments, can mean approval for a property worth far more than you could afford in all cash. Higher-quality properties mean premium rental rates and greater cash flow.
Someone else pays the bills
The sticking point to leverage is that you must always pay it back. Thankfully, for investors, you’re not paying it back with your own money. Rent goes towards the mortgage for a while, so you build equity without putting in much yourself. The lender secures the property for you, and the residents pay it off. You reap the benefits!
The Cons of Utilizing Leverage
The dangers of debt, or over-leveraging
It’s possible to overleverage – to take on debt that outpaces your ability to pay it all off. This can impede your ability to save, budget effectively, and further invest. It can also happen if you have negative equity. So, while leverage can be enormously valuable, investors can paint themselves into a financial corner if they aren’t prudent about it.
Your cash flow will be affected
You’ll have to pay the mortgage off if you utilize lending to acquire investment properties. The good news is that you don’t have to do it with your own money. That said, the bulk of passive income from each rental property will go to mortgage payments until you pay the property off.
Lenders get their money first
Ultimately, the lender is going to get paid first. If you sell a property, that balance is paid first. While it’s not usual for property owners to owe more than their property is worth, it creates risk. If, for whatever reason, you can’t pay the lender, they can come after other assets or repossess the property.
Limits to leveraging
Investors can’t utilize leverage infinitely. Most lenders have a limit to how many mortgages someone can juggle at one time. Additionally, your debt-to-income ratio can impact the terms of future loans. Investors must wisely take on the right amount of leverage and keep it under control.
The rise and fall of interest rates
Interest rates are a big hurdle in today’s market. With property prices as high as they are, every fraction of a percent can add hundreds of dollars to a monthly payment. Investors must keep their credit score up and develop a good relationship with the right lender to secure the best terms possible. If you pay in all cash, there’s no interest rate. And for some, that’s worth the delay.
Ultimately, investors have much to gain from utilizing leverage. But as with anything, they must adequately evaluate the benefits and risks involved.
Did you know that every three out of four REI Nation investors use leverage as part of their investing strategy?