Leverage is one of those words that you might have heard of, and you possibly have a vague idea of what it means. You might not know precisely what it is or some of the things to consider.
So, what is leverage?
People talk about leverage and people also talk about gearing and what does it all mean?
It is about borrowing money and (in theory) using that borrowed money to maximize your returns. The most common form of leverage people use is a buy-to-let mortgage. To give you an idea of how leverage works, we have two examples.
The first example has no leverage involved, and the second example will look at leveraging and maximizing our returns, by showing exactly how it would work. We have kept the examples as simple as possible to help you understand.
So, our first example:
If you have £200,000 in cash and you go and buy one property for £200,000, the benefits you will have is it buys you the property outright, you have no mortgage. Therefore, all the rent that comes in, less the minor costs are yours and you also have no mortgage payments to pay. Not only that but you will also have a much lower risk by buying in cash and not using leverage.
In the second example, we are going to use leverage. We are going to split up our £200,000 into four equal chunks i.e £50,000 per chunk. We are now going to buy four properties worth £200,000 and use mortgages of 75% loan to value on each one.
Each of the properties is going to have £50,000 deposit and a £150,000 mortgage. You might be thinking, but, there are other costs involved and yes, there are but we are just trying to keep it simple for example purposes. So, we now have four properties and we have got the rent coming in on all these properties but, we do have mortgage payments to pay.
Over time the property market rises and as it always has done at some point property prices will rise by 25%. So, in the first example, the property that was worth £200,000 it is now worth £250,000 which is a great 25% return on our investment over time due to the property market going up on paper.
Now, if we look at example two, our first property is worth £250,000, so is our second, our third and our fourth. Each has gone up to £250,000, therefore we have made £50,000 profit on each property which comes to £200,000. So, on that original £200,000 we put in, we made a 100% return on our investment because we used leverage. What is also interesting is we started with the same amount of money but because we took advantage of leverage we managed to double our return. So instead of £50,000, we made £200,000 which is huge and a massive difference.
That is why so many property investors get excited by leverage and the potential it offers over the long term. It’s one of the biggest wealth creation tools you can use. You may be thinking “mortgage is a debt, so isn’t it better to buy in cash?” Well, let’s dive a little deeper into the details.
Why are the majority of investors happy to take on the debt?
A lot of people are told that it is bad to be in debt and to some extent they are right. However, you need to make a distinction between good debt and bad debt. Bad debt is something like credit card borrowing where you are just using it to buy a kitchen, go on holiday, or something else. These are going to depreciate or where it is an experience like a holiday, you are going to have it, and it’s going to be over.
However, debt in the form of a mortgage is something that you’re taking on very deliberately because you know you can make more money as a result of taking on that debt. It is not like you are going to take it and spend it on other things. You are going to use that money to buy an asset which (in theory) is going to generate an income for you and appreciate over time.
Although it is a debt, it is not like it is credit card debt where it’s meant to be short-term and has huge interest rates. Mortgage debt is a structured product which has got an affordable interest rate. It is designed to be over a long time and you can even fix it, so you know exactly what your payments are going to be.
If you think seriously about it. It’s not worth thinking of it as a debt but instead, think of it as buying power. What it does do is maximize your buying power and maximize your return on investment. So, in other words, you are taking your own money and you are amplifying the effects of the return that you get by using the mortgage lenders money. In the short term, it is going to eat into your profits because you have got interest payments that need to be paid, but over the long term when you get capital growth you get a greater Return On Investment (ROI).
You can, of course, have leverage at any level, you might just borrow a little bit of money or you may borrow the majority of the money that you need to buy a property. Beware, you can overleverage and if you do it will not work out well!
A Word of Warning – As explained by using leverage you can make a much bigger gain, but it can potentially make much bigger loses as well. In our second example, the property market was up by 25% and you made £200,000 by leveraging. However, if the property market dropped by 25% and you were forced to sell the properties, then technically you would have lost £200,000 from the money you originally invested.
The important thing to remember, particularly if you are new to property, you only lose money if you are forced to sell. So, when the property market dips at certain parts of the cycle as it does, don’t worry they will go back up over time.
Leverage is fantastic as a wealth creation tool for making money long term but just be careful and cautious that you don’t over-leverage yourself, so your cash flow is restricted. This is just something to be cautious of when you’re investing over time and it’s only a problem if you are forced to sell because that just means that you’re not going to be in a position to get the best price and you might be forced to take a loss at exactly the wrong time.
You need to work out, what your comfort level is and know what property to buy to make money. You may be worried about things like interest rates, which are currently, at a historic low, but they are only going to be going in one direction at some point and that will be upwards.
You should budget that in when you stressed tested your portfolio at higher interest rates. Some people just do not want to be worrying about that happening and if it is going to be keeping you awake at night worrying about what that’s going to do your repayments then maybe a smaller mortgage is the right way to go. If you were to only borrow 50% of the money to invest then that is still going to do a lot to your buying power and still give you a lot of room for interest rates to go up without affecting, you too much.
Leverage is there for a reason and it is one of the best things about property investment. You will not be able to get a bank to lend you money to invest in the stock market or classic cars. Property is pretty much the only thing where you get to take advantage of this.
So, there you have it, that is leverage, and if you are new to property, we hope you have learned a lot and if you are an experienced investor, we hope it has clarified it for you.