Some may feel that the concept of “leverage” is difficult to fully grasp, but it’s an important one for borrowers to understand. Leveraged loans let you get a little more bang for your buck when it comes to real estate investing. This is especially true if you don’t have a lot of capital to work with in the first place. Before you decide whether leveraged lending is right for you, read on to learn how it works.
What is a Leveraged Loan?
The concept of leverage is pretty simple: You borrow money instead of providing all of the capital yourself in order to get the most out of your own money. In real estate, this means that instead of purchasing an investment property outright in hopes of selling later on at a profit, you instead use your funds as a down payment on more expensive properties. When it’s time to sell, you’ll profit not only on your own invested cash, but also the money that you borrowed.
Here’s an example. Let’s say that you have $200,000 available to invest in real estate. You could use that money to buy a $200,000 home outright to resell later. Or, you could split that $200,000 into two $100,000 down payments on two $500,000 homes. By securing two loans for each of these properties, you’ve put leverage to work.
So where does the increased profit come in? In the original example, you purchased a $200,000 home outright. If you were to hang on to that home for one year, and if real estate in your area increased by 5% in that year, then the selling price for the home should be $210,000 — a profit of $10,000 for you.
If you used leveraged loans to purchase two $500,000 homes using $100,000 down payments apiece, you would make more in this scenario. These two homes, again with a 5% appreciation rate over one year, would now sell for $525,000 each, which adds up to $50,000 in profit for you. The concept of leveraged loans applies to both traditional and hard money loans.
What are the Pitfalls of Leveraged Loans?
There are two major things that you’ll need to look out for if you decide to pursue leveraged loans:
- Interest rates can dip into your profits. Interest is paid each month with the loan payments. The longer you wait to resell your investment properties, the more interest you’ll end up paying. Additionally, those rates will vary depending on how much leverage you choose and how long the loan term will be. Today, conventional rates are sitting around 3.6% for 15-year fixed rate mortgages and that cost goes up for longer terms or loans with less than a 20% down payment. Hard money loans have a higher interest rate than traditional loans, so you will want to make sure your real estate project moves swifty in order to maximize the benefits.
- Get to know the area that you plan to invest in. Make certain that the market is in an upward swing. If home prices are not rising, or worse, if they are falling, then you’ll end up losing money.
Leveraged loans are a great way to make money work harder, especially for would-be investors that have limited funds. Choose your investments wisely and you can make far more than if you pay in full on your properties.