One of the most attractive elements of property investing is the ability to Leverage a smaller amount of your own money to control a much bigger asset. Banks will allow you to fund the deposit on a property purchase and lend you the balance in return for paying them regular interest.
Let’s use two examples to demonstrate the power of Leverage:
If you had $100,000 in either cash savings (or accessible equity within a property), achieving a yearly return of 5% interest (or capital growth), the balance of this amount would increase by $5,000 in one year.
Alternatively, you could Leverage that $100,000 as a 20% deposit on an investment property worth $500,000 with the remaining $400,000 borrowed from the bank:
Assuming the same 5% annual return as above, the capital growth on $500,000 would be $25,000 in one year, which is five times the return of $5000.
This means that your original $100,000 has grown to be $125,000, which equates to a Return on Investment (ROI) of 25% in only one year! That clearly outperforms the return of leaving your money in a savings account or leaving your accessible equity in your home untouched. You do need to take into account the interest repayments over the term of the loan but the income received from rent will help offset this.
It would be irresponsible of me to talk up the use of Leverage without pointing out the potential downside. The above example shows Leverage has the ability to magnify your gains if property prices go up, but on the flip side it also has the ability to magnify your losses if your property value drops below the price that you purchased it at. The value of the property could become less than the outstanding loan amount and this is known as having Negative Equity, but history shows that due to inflation, property prices do increase over the long term. If the property’s value was to fall in the short term, the bank will not necessarily demand the loan to be repaid unless you cannot meet the minimum interest repayments. A carefully selected investment property in an area that is poised for future growth will mitigate the risk of a loss in value and this is why property is ideally a long term (10 year minimum) investment.
In summary, when Leverage is combined with time and the returns are allowed to compound over the long term, the difference it can make to your future wealth can be substantial.
In my next post I go in to more detail on Leverage and what effect it can have over the long-term, you can read that here.