For the most part, your investing power is constrained by the funds available to you. If you can invest $1,000,000, you’ll see more impressive nominal returns than someone who can only invest $10,000, even if your strategy is inferior in some way.
Intuitively, you may believe that there are only a few methods available for access to investing funds. You can try to make more money, you can free up capital by selling some of your assets, or you can reinvest returns generated by other investments.
However, there’s another way to increase your investing power, and it’s relatively accessible even to new investors: it’s called financial leverage and it could be exactly the tool you need to see better returns in real estate.
The Many Aspects of Real Estate Investment
First, understand that there are many different ways to approach real estate investing. You can choose to invest in residential or commercial properties. You can invest in a wide range of different areas. And you can invest with different goals in mind, such as cash flow or long-term appreciation.
One of the most popular strategies in real estate is investing in rental properties, which you’ll be responsible for managing. In this arrangement, you’ll find tenants to occupy your property, charge them monthly rent, and use that rent to cover expenses as well as generate a small profit.
Returns on individual properties with one or two units are typically small, so most investors make it a goal to expand their portfolios with further real estate purchases. This is where financial leverage comes into play.
What Is Financial Leverage?
Financial leverage is using borrowed funds to artificially increase your investing power. For example, if you have $20,000 in the bank, you ordinarily wouldn’t be able to buy a $200,000 property. But if you’re willing to take out a mortgage, you could use your $20,000 as a down payment and borrow the rest, functionally getting access to a $200,000 property with only $20,000 in capital.
There are obviously some risks and downsides to this maneuver. You’ll be responsible for paying back the loan even if the property falls in value. You’ll be forced to pay interest on whatever you borrow. And increasing your debt may limit you in other financial areas.
But the upsides are incredible. You can invest in properties much faster and invest in more properties with the use of financial leverage. You can benefit more strongly from property appreciation. And you don’t have to stake as much of your own Personal Capital, so you can save it for other endeavors or personal expenses.
How to Use Financial Leverage to Your Advantage
So how do you use financial leverage to your advantage?
· Solidify your qualifications as a borrower. You’re not going to have access to financial leverage if you don’t qualify for any borrowing opportunities. You should therefore make it a priority to improve your qualifications as a borrower, such as by paying off your other debts, increasing your income, and more importantly, improving your credit score.
· Be mindful of interest rates. The Federal Reserve has the authority to adjust the federal funds rate, which in turn, typically influences interest rates for financial products across the board. The going interest rates for mortgages play a huge role in how advantageous it is to borrow money; a 3 percent mortgage interest rate is much, much more favorable than a 9 percent mortgage interest rate. Lean toward taking advantage of financial leverage when interest rates are favorable.
· Keep an eye on inflation. Inflation decreases the value of money, decreasing its purchasing power. But it also has an interesting effect on debt; holding debt during inflationary periods reduces the buying power of money, but the nominal amount you owe will remain the same. In other words, inflation favors borrowers. While nobody can predict inflation or the economy perfectly, it may be advantageous to take out loans before and in the early stages of inflationary growth.
· Provide the minimum down payment (when it makes sense). The more you borrow, the more leverage you’ll have. When the conditions are favorable, consider making only the minimum down payment, even if you can afford more.
· Build good relationships with lenders. As you flesh out your real estate portfolio, work on building better relationships with lenders. It will make the process of getting loans much smoother in the future.
· Consider forming new partnerships. Banks aren’t the only institutions that can increase your buying power. Consider forming new partnerships with like-minded investors as well.
· Be cautious to avoid over leveraging. It’s possible to over leverage yourself, taking out so much debt that the risk profile is no longer advantageous. This threshold is different for everyone, so exercise caution to spare yourself from this eventuality.
· Always diversify. As with all financial endeavors, it’s important to diversify your portfolio. That means investing in a wide variety of different assets, different areas, and different types of properties. The more diversified your holdings are, the less overall risk you’ll face.
Financial leverage is generally advantageous, but you still must use it strategically if you want to minimize the downsides and maximize your potential returns. The more experienced you get in the world of real estate investing and personal finance, the more you’ll develop a kind of intuition for when financial leverage makes sense.
