Leverage is a very simple principle in the physical world. You use one or more objects to multiply the force it takes to move a bigger object. For example, in the illustration above, with the right tools the smaller rock on one end can move the larger rocks on the other end. Using the principle of leverage, the cave man figured out how to move big boulders to provide shelter for his family. This was the start of civilization.
The Power of Financial Leverage in Real Estate Investing
Leverage in the financial world is very similar to leverage in the physical world. Instead of using a smaller rock to move a larger rock, you use a small amount of cash, in combination with debt, to make a much larger investment. Leverage has the effect of multiplying the return on investment. With a small initial equity (cash) investment, you gain control over a larger investment and you reap the returns on the larger investment.
Let’s look at a few examples. In the first example you purchase a $100,000 investment with $20,000 of equity and debt of $80,000. In the second example you purchase a $100,000 investment with $10,000 of equity and debt of $90,000. In these two examples, both have a 10% gain.
As you can see from the table, a gain of 10% generates a 50% return on equity with a 20% investment compared to a 100% return on equity from a 10% equity investment.
Using leverage can mean huge rewards for a real estate investor. Imagine you had $100,000 in an IRA, 401K account, or a savings account that was available for investment. You could use this capital as a 20% down payment on a $500,000 investment property. Assume the property appreciates at a moderate rate of 8% per year for three years. At the end of the three years the equity in the property has increased over $120,000, a return on equity of 120%. When was the last time your stock fund, savings account, or IRA performed like that?
Now, just imagine you could take the $220,000 above (initial $100,000 + $120,000) in equity and gained control of a $1,000,000 investment property. If the $1,000,000 investment property appreciates at the same 8% rate, the equity will grow by $80,000 per year. That’s power of leverage!
Conclusion
In The Savvy Investor Program™, we teach you how to create your own economy. We help you get off the treadmill. Remember that with real estate investing as one part of your financial plan, you can create the life of your dreams by following a few time-proven strategies and techniques. Today, buy your copy of The Book on Investing.
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