How Leverage Gives You an Advantage When Financing an Investment Property

Leverage is a term that's often used in the world of real estate investing. Simply put, leverage refers to the use of borrowed funds, or downpayment, to invest in real estate. This financing allows investors to purchase more property than they could otherwise afford with their own capital, thus amplifying potential returns and decreasing the amount of initial outflow of capital.

Read on to explore the ways in which accessing high leverage to finance an investment property can give you an advantage in the markets, the benefits and drawbacks, and some of the most common financing options.

First, let’s look at leverage

Real estate investors use leverage in a variety of ways. One common approach is to take out a traditional or hard money loan to purchase a property. You put down a portion of the purchase price as a down payment and then borrow the remaining amount from a lender. The financing is secured by the property, meaning that if you’re unable to make payments, the lender can seize the property to recoup their funds.

Using leverage can increase your potential returns on investment. If you put down 20% on a property and borrow the remaining 80%, then any appreciation in the property's value is amplified by a factor of five (since your own capital is only 20% of the property's value). This can lead to significant profits if the property increases in value over time.

In reality, financing an investment property with high leverage can give you a significant benefit in the real estate market, and here's how:

Maximize Cash Flow

Financing an investment property with high leverage allows you to maximize your cash flow by putting less money down upfront. For example, some hard money or non-qm lenders offer leverage up to 90%, meaning you only need to put 10% down. This means you can invest in more properties with the same amount of money. For example, if you have $100,000 to invest, you can buy one property outright or finance two properties and use the rest of your cash for other investments or rehabs.

Build Equity

Financing a rental property allows you to build equity over time. As you pay down the loan, you own more and more of the property. Additionally, as the property appreciates in value, your equity increases even more. This means you can use the equity in your rental property to finance other investments or to pay down debt.

Increase Returns

Financing an investment property can increase your overall return on investment (ROI). Let's say you buy a property for $200,000 and finance $150,000 of it. If the property appreciates by 5% over the next year, it's now worth $210,000. Your ROI on the property is 10%, even though you only invested $50,000 of your own money.

Tax Benefits

If you’re financing a rental property, there are tax benefits as well. You can deduct mortgage interest, property taxes, and other expenses related to the property from your taxable income. This can significantly reduce your tax liability and increase your cash flow.

Diversification

Finally, financing an investment property allows you to diversify your investment portfolio. Real estate is a great way to diversify because it doesn't necessarily move in the same direction as the stock market.

Are there risks associated with high leverage?

High leverage can also come with risks. If the property's value decreases, you may owe more on the mortgage than the property is worth (known as being "over-leveraged"). This can make it difficult to sell the property or refinance and may result in your taking a loss. Additionally, if the property is not generating enough rental income to cover the mortgage payments, you may need to use your personal funds to make up the difference.

Financing options for investment properties

Let’s explore some of the most popular financing options for investing in real estate:

Hard Money Loans

Hard money loans are a popular financing option for fix and flip or rental property investors. These loans are typically offered by private lenders and secured by the property. Hard money loans typically have higher interest rates and fees than conventional mortgages, but they can be a good option if you need to close on a property quickly or if you have poor credit.

DSCR Rental Loans

DSCR (Debt Service Coverage Ratio) rental loans are a type of financing available to real estate investors who own income-producing properties, like single-family rental homes, condos or multifamily buildings. These loans are specifically designed to provide financing for real estate investors who are seeking to purchase or refinance a rental property and want to ensure they have enough cash flow to cover their monthly mortgage payments.

Traditional Mortgages

A traditional mortgage is a popular financing option for property investors. These loans are backed by Fannie Mae or Freddie Mac and are typically offered by banks and other traditional lenders. Traditional mortgages typically require a down payment of 20% or more and come with competitive interest rates.

FHA Loans

If you don't have a large down payment, an FHA loan may be a good option for you. These loans are backed by the Federal Housing Administration and typically require a down payment of only 3.5% of the purchase price. However, FHA loans come with stricter eligibility requirements and may also come with higher interest rates and fees.

Home Equity Loans

A home equity loan may be a good way to finance your rental property investment if you already own a home. With a home equity loan, you can borrow against the equity in your home to finance a rental property purchase. However, home equity loans typically come with higher interest rates and fees than conventional mortgages.

Private Money Lenders

Private money lenders are individuals or companies that offer short-term loans to investors. These loans typically have higher interest rates and fees than traditional mortgages, but they can be a good option if you need to close on a property quickly or if you have poor credit.

Bottom Line

In conclusion, financing a rental property with high leverage offers investors a more profitable advantage in the real estate market. You can grow your wealth over time by maximizing cash flow, building equity, increasing returns, enjoying tax benefits, and diversifying your portfolio.