Welcome, back!There is something about leverage that appeals to almost everyone. It’s a controversial topic among investors, particularly in whether it can be a great help or a path do misery.
We have a lot of examples and types of leverage. For me, the most common use of this instrument is to buy a house – through mortgage loans. This enables an individual to invest immediately without waiting years saving the full amount. On the other hand, after taking the loan, the borrower has to repay the loan plus the interest. And this could be a huge hurdle for our financial independence.
Leverage can be used in other situations like:
- Companies: in the form of debt to finance operations;
- Investors: that borrow capital, through a variety of financial instruments, to invest in financial markets;
Today I will focus more on using leverage for the real estate.
My personal view is that leverage can amplify the potential returns of an investment. In the case of real estate, this is especially relevant, because leveraging can allow me to start investing without having all the money necessary to buy a house or building upfront. Therefore the returns can be higher when compared with returns in a situation where you can only use your capital.
“Give me a lever long enough and a fulcrum on which to place it, and I shall move the world,” wrote Archimedes.
First of all, it can – sometimes greatly – increase the risk associated with the investment. Hence if something fails, not only I can lose my money, I can stay in debt for an asset that doesn’t have the initial value.
In addition, the higher the interest rate and/or the years to repay the loan, the higher you pay for it. I have a simplistic way of thinking this: for every loan that has a duration of 40 years with a 4% interest rate, you pay 2 houses, but you only get 1.
How to Approach Leverage in 3 Simple Steps
- Risk: First of all when investing with leverage, it’s important to decrease the risk as low as possible. Evaluate the asset over and over again. Negotiate to pay the minimum possible for that asset. Hence decreasing the amount to borrow;
- Interest Rate: Another important issue is to reduce the interest rate. Consequently, I would negotiate with every bank if I have to. 1% less is a huge victory. Remember the “40 Years/4% Interest Rate”;
- Duration of the loan: Finally and equally important is to reduce the duration. I would pay the loan in advance if I can. Again remember the “40 Years/4% Interest Rate”.
While recognizing that there are other important issues like taxes, for example, I would say (generally speaking) that risk, interest rate and duration of the loan, are the issues that I believe should be carefully considered when thinking in leverage to invest in real estate.
Finally, what do you think about this?
See you soon!
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