Leverage is a term that is often used synonymously with debt, and for this reason, it is important that people come to understand what debt leveraging actually means, and how it works in an ordinary financial transaction, such as buying a home for example. Let us suppose that you are looking to make a purchase of a home as an investment, and this hypothetical home costs $100,000. Let us say that you expect to earn approximately $600 every month by renting the home out to another family. If you were actually fortunate enough to have the full $100,000 amount in your savings and you bought the home outright for cash, and you sold that house a year later for $110,000, then you will have realized a before tax gain of $17,200 on your investment, which includes 12 months of $600 rent per month and the $10,000 appreciation accrued on the property's value. Should you divide the proceeds earned by the investment made, then you will have earned a yield of 17.2 % on your capital of $100,000.
Most people, however, do not have $100,000 in the bank. Even if they did have this kind of money simply lying around, they understand that it would not be wise to tie it all up in a single investment. So let us suppose instead that you purchase the home by making a down payment of $20,000, and borrowed the balance on the purchase price, for the sum of $80,000, using a mortgage secured on the property. If the mortgage rate was 12%, then you would be making payments of approximately $800 every month, and you would be able to cover them from the rental income since they would be tax deductible.
When you sold the home at the end of the year for the $110,000, you would end up with a total net gain of $10,000, assuming that the rent was only enough to cover the loan payments, so this would be a gain of 50% on your investment of $20,000 for the down payment initially. If you had $100,000 to play with in the market at the time, you could do this same thing for five homes in the market and would have ended up with a total gain of $50,000, compared to a non-leveraged gain of only $17,200.
This is the concept of debt leverage, and it works not only with real estate but also with trading stocks using margin, taking over companies in leveraged buy outs and other financial strategies as well. Unfortunately for many people, leverage can be a double edged sword because what it does is magnifies the effect of the change in price in comparison to the original investment that you made. If the market should happen to move in your favor, but if the market moves against you then your losses will be magnified and can total a lot more than your original investment.
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Originally posted 2009-01-13 05:09:10. Republished by Blog Post Promoter
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Debt, Leverage, Money, Personal Finance, Real Estate
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1 comment so far ↓
Yep, and the biggest danger with debt leverage is when the magnified losses become more than your original investment. Probably not a danger at the moment but beware the time when people say “it can never happen”. It’s usually time to exit the market
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