Mortgages: The Wealth-Building Power of Leverage.
I thought this week I would take a moment to discuss the amazing power of leverage in real estate; perhaps your strongest ally when considering investing in property. An understanding of the simple principle behind this valuable tool will allow you to more completely evaluate the real advantages that come from ownership.
Leverage is defined by the Ontario Real Estate Association as ‘the use of borrowed funds to make an investment in real property in the hope of realizing a profit in addition to monies necessary to pay for the borrowed funds’. So what exactly does that mean? It means: using other people’s money (the bank’s) to make more money than you can make by using only your own money. Great! But how precisely does that work?
The easiest way to visualize leverage at work is via example, so here goes:
Let’s say Ms. Jane Homebuyer has $50,000 to invest as a down payment on a property. Jane buys a house in Toronto worth $250,000 (good luck!), borrowing the rest of the purchase price from her lender in the form of a $200,000 mortgage. Jane’s bank gives her an interest rate of 4% on the loan. She then waits one year and sells the house for a profit because real estate in Toronto has gone up 10% in value that year, known as the capital appreciation of the asset property. The 10% increase meant Jane sold her house for $275,000.
Has anything interesting happened here? Let’s see! (We will keep it simple and leave out some of the smaller details of the transaction to focus on the broader picture.)
When Jane pays back the bank for her $200,000 mortgage* out of the sale proceeds, she will have $75,000 left**. If we look at the cost of her own initial cash investment ($50,000) and compare it with the net proceeds from the transaction, it quickly becomes apparent that Jane has in fact made 50% interest on her money in only one year! Because the bank allowed her 5 times the leveraging power of her money, she actually made quite a bit more than the 10% that the simple market appreciation represents.
Looking slightly deeper, we see that a truer picture can be formed by including the cost of borrowing the money into our analysis. Jane paid 4% interest as a fee for using the bank’s money. So in fact, we should subtract that amount from the overall gains Jane realized, leaving us with an actual rate of interest of 6% in Jane’s favour for the borrowed funds.
The critical take-away point is that Jane is making 6% net on $200,000 of someone else’s money. Not bad! Now imagine if Jane would have used the same $50,000 as a 5% down payment on a $1 million property! (Hint – $50,000 becomes $150,000 in one year) Amazing!
The power of leveraging the bank’s money is how wealth is generated through real estate, and taking on some of this ‘good debt’ is how fortunes are made in the investment game. Borrowing is not without some risk, however, so each investor should decide their own level of risk tolerance by carefully weighing their options with a professional.
On that note – call me and we can discuss how to get your money working for you now.
Until next time,
Shaun Nilsson
1-888-712-7888
* – this number is slightly inaccurate. After one year, Jane will have ‘paid down’ some of her mortgage by contributing to principal through her payments – effectively reducing the amount owed.
** – not taking into consideration possible fees, taxes, etc.
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@ January 19, 2010 at 7:22 am
Investors: Never Pay Off Your Mortgage. | Shaun Nilsson, Toronto Real Estate Agent says:
[...] if you’ve been a reader of the Monday Morning Memo for long. The concept here hearkens back to my 2009 article on leverage and is built around the same [...]