One of the most powerful tools in real estate investing is leverage, which allows investors to use borrowed funds to acquire properties, maximize returns, and grow their portfolios faster than using just their own capital. When used strategically, leverage can significantly amplify profits, but it also comes with risks that investors must understand.
In this guide, we’ll explore how to use leverage in real estate investing, its benefits, risks, and the strategies that can help you succeed in building a profitable portfolio using other people's money (OPM).
Disclaimer: The information in this article is for educational purposes only and does not constitute financial, tax, or legal advice. Consult with a licensed financial professional before making any investment decisions.
Additional reading: Real Estate Financing Options
In real estate, leverage refers to using borrowed capital to finance the purchase of a property. Instead of paying the full purchase price out of pocket, investors use loans, mortgages, or other financing options to cover a portion of the cost. This allows you to control a larger asset with less of your own money, maximizing your potential return on investment (ROI).
For example, if you buy a $200,000 property with a 20% down payment ($40,000), you borrow the remaining $160,000. If the property increases in value by 10% to $220,000, your equity has grown to $60,000, giving you a 50% return on your initial $40,000 investment—this is the power of leverage.
Leverage is a powerful tool that allows investors to multiply their returns. Here are some of the primary benefits of using leverage to finance real estate investments:
When you use leverage, you can earn a higher return on investment because you're using less of your own money to control the asset. Even a small increase in property value can lead to significant gains on your initial capital.
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Leverage allows you to stretch your capital and invest in multiple properties rather than being limited to one. Instead of using $100,000 to purchase one property outright, you could use that same amount to make down payments on two or three properties, each of which could generate income and appreciate over time.
Real estate investors who use leverage can benefit from tax deductions on mortgage interest payments. In many cases, the interest paid on the loan is tax-deductible, reducing your taxable income and improving your overall returns.
Real estate has historically been a strong hedge against inflation, and leverage can amplify that benefit. As inflation rises, property values and rental income typically increase, but your loan payments remain fixed (in the case of a fixed-rate mortgage), effectively reducing the real cost of your debt over time.
While leverage can significantly boost your returns, it also comes with risks. Understanding these risks is crucial to using leverage safely and effectively in your real estate investments.
Just as leverage can amplify gains, it can also magnify losses. If the value of the property decreases, your equity can be wiped out quickly, and you could owe more on the property than it’s worth (also known as being underwater on your mortgage).
For example, if you purchase a property with 20% down and the property value drops by 10%, you’ve lost 50% of your equity. In extreme cases, a significant drop in property values could result in foreclosure if you’re unable to make the loan payments.
If you use too much leverage, your monthly loan payments could exceed the rental income generated by the property, leading to negative cash flow. This puts you at risk of falling behind on payments, which could lead to missed mortgage payments or default.
Real estate values can fluctuate due to changes in the local market, economic conditions, or interest rates. When you rely on leverage, these market risks are amplified. A downturn in the market could leave you with less equity or make it harder to refinance or sell the property.
If you use an adjustable-rate mortgage (ARM) or any loan with a variable interest rate, you’re exposed to the risk of rising interest rates. Higher rates can increase your monthly payments, reducing your cash flow and making it more difficult to cover expenses.
There are several ways to finance real estate investments using leverage. Choosing the right financing option depends on your financial situation, risk tolerance, and investment goals.
A conventional mortgage is one of the most common ways to leverage real estate. With a conventional loan, you make a down payment (usually 20-25%) and borrow the remaining amount from a lender. The loan is repaid over a fixed term (15, 20, or 30 years), with either a fixed or adjustable interest rate.
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The Federal Housing Administration (FHA) loan is an excellent option for first-time investors who want to start by house hacking—living in one unit of a multi-family property while renting out the others. FHA loans require lower down payments (as little as 3.5%) and are easier to qualify for, but they require the property to be owner-occupied.
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A home equity line of credit (HELOC) allows you to borrow against the equity in an existing property. It’s a revolving line of credit, meaning you can borrow, repay, and borrow again as needed, making it a flexible option for leveraging existing real estate investments.
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Hard money loans are short-term, high-interest loans that are typically used for fix-and-flip projects. These loans are secured by the property itself, rather than your personal income or creditworthiness, making them a faster and more flexible financing option.
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While leverage can be a powerful tool, it’s essential to use it wisely to avoid unnecessary risk. Here are some best practices to consider:
It’s tempting to maximize leverage to buy more properties, but too much debt can lead to negative cash flow and increased risk. A good rule of thumb is to keep your loan-to-value (LTV) ratio below 75% to ensure you have enough equity to cushion against market fluctuations.
When using leverage, make sure the property generates enough rental income to cover the loan payments, operating expenses, and other costs. Maintaining positive cash flow will help you manage the loan and reduce the risk of default.
Opt for fixed-rate loans whenever possible, as they provide stability and predictability. Fixed-rate mortgages ensure your payments remain the same, even if interest rates rise.
Rather than putting all your eggs in one basket, diversify your investments across different property types and locations. This will help reduce the risk if one property or market underperforms.
Leverage can be a game-changing tool in real estate investing, allowing you to grow your portfolio, maximize returns, and take advantage of market opportunities. However, it’s essential to understand the risks involved and use leverage carefully to avoid overextending yourself.
For investors seeking opportunities to grow their portfolios, platforms like mogul provide access to professionally managed real estate projects, offering an easy way to invest in high-quality properties without the hassle of direct ownership. With mogul, you can enjoy the benefits of leverage and real estate investing while minimizing risk.
Disclaimer: The information provided in this guide is for educational purposes only and does not constitute financial, tax, or legal advice. Always consult with a licensed professional before making any financial or investment decisions.