Pros and Cons of Leverage

Some people think that leverage is a bad thing. Having a ton of credit card debt or any high-interest consumer loan is terrible because you can end up paying out a lot in interest. So you’d want to get rid of that as soon as possible.

But when you look at leverage for a business purpose, it can be amazing as it gives you the ability to do things you otherwise wouldn’t be able to.

Leverage isn’t perfect though. There are upsides and downsides to it. And we’re going to go over them now.

Debt Allows You to Spread Your Risk

Without leverage, if you want to buy a million-dollar home, you’d have to put out the entire million. Even if you have that money, it still means all that money will be tied up to that one house. That’s too risky.

With leverage, you can instead use the $1M you have on hand to make the 20% down payment on 5 houses. This way, you’d be spreading the risk.

Debt Lets You Earn 100% Of The Appreciation

Later, when you sell that million-dollar property, if you were able to sell it for more than what you paid for it, then it means that property appreciated.

Your lender only makes money from the interest payments you make on the debt. So you will earn 100% of the appreciation on your property.

Lenders Get Paid Back First & Can Go After Your Other Assets

There are downsides to this though. If things go bad, your lender will do everything to recoup the amount of the loan. Say you took out a $1.5 million loan to buy a house. If you were forced to sell the house for only $1M, the lender will take the entire amount, leaving nothing for you.

On top of that, if it’s a recourse loan, the lender can go after your other assets to try and get back the $500,000 that didn’t get covered by the sale.

Equity Offers Less Risk But Less Profits

Another way to get leverage is by partnering with people. So instead of debt, you finance the property through equity. If the deal makes money, you and your partners share the profits, but if the deal ends up being a loss, you and your partner just walk away.

However, you make less profit from partnering with people compared to when you take out a loan.  With equity, your partner benefits from the appreciation of the property, which could be more than the interest payments you could have been paying if you took out a loan.

Hard Money Loans Let’s You Put Less Money Down

If you have a property that you know you can go in and out of very quickly, then a hard money loan would be great because you can buy a property at 90% loan-to-value. So you’d only be putting in a 10% down payment.

Equity Is Better For Long-Term Projects

But for a property that you’re not able to get out of quickly, having an equity partner is better because you can opt to rent it out or do an Airbnb while you wait for the market to get better.

Also, you won’t have to worry about making those monthly interest payments unlike if you took out a hard money loan.

Worse Case Scenarios With Debt

Leverage can end up being really bad for some. Let’s say you have too much debt. If everything goes bad, you’re screwed.

For short-term debt, banks want their money at a certain time frame. You can refinance, but some people have experienced (like in the case of Dave Ramsey) that banks didn’t let them refinance. So they had to pay back the entire loan right then and there.

It’s All About Balancing Everything

To make sure you don’t end up experiencing the terrible scenarios above, what most investors who don’t have a lot of funds do is this.

Leverage to get as much as they can from the bank. Once they have some money, do 70% or 80% loan-to-value (LTV) loans to get lower interest rates. If you have more money in the deal, the hard money lender will give you better rates and better points.

With this, however, you can do fewer deals because your money is stuck in each project.

Some people do second position loans where banks only give you 90% of the loan. The remaining 10% comes from another investor. The investor can either take a debt position or an equity position.

Those taking a debt position can be offered something like 12% interest for providing 10% of the loan amount. On the other side, those who an equity position get to split the profits made on the deal.

Conclusion

So there you have it, you can get very creative with leverage. And it offers a big opportunity for investors like us to build our portfolio.

Just make sure that you manage your debt carefully, and you could be on your way to reaching real estate success.