Leverage

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Investing your own money is scary enough, borrowing money to invest is probably something we would never consider doing.  Despite that feeling of fear of borrowing, millions of people still borrow money to buy houses.  If we have a fear of borrowing money and going into debt then perhaps you should consider … is purchasing a house really risk free?  If you fear borrowing to invest, why do you not hesitate when buying a house?

The argument for real estate as an investment vehicle is always prominent.  Housing is a necessity of life because we need a roof over our heads, we are not making any more land in this world, and perhaps mom always said buying a home is the best investment.  Just because everyone needs a roof over their head does not mean that real estate is a risk free investment.  Most of us will not be fortunate enough to buy a house without borrowing money.  The majority of home buyers pay less than 25% of the initial cost of the home when they purchase it.  For investors trying to buy a second home, the down payment drops drastically even lower.  What many people are doing when borrowing money to invest in a home is using leverage.  When it comes to leverage, it equates to greater risk.

The reason why buying a house as an investment is so lucrative is that it enables ordinary individuals to only put a relatively small amount of money towards purchasing a very expensive asset.  The fact that you can purchase an asset that is 10x, 20x, 30x or maybe even 50x your initial investment makes it a very lucrative investment. A house, not surprisingly, is one of the few investments that a bank is willing to lend money to buy.  If you tried to borrow a large sum of money to play in the stock market, I am absolutely sure the bank will refuse.

Imagine this scenario, you put $20k down payment on a condominium purchased at $300k.  A year later you sell it for $320k.  If all other factors were taken out and you were able to pocket $20k from that transaction, you’ve doubled your money!  In essence, the condominium might have only risen 6.7%, but you made a 100% profit.  That’s the power that leverage gives you.  By purchasing an asset that is 15x your initial investment, you were able to reap the benefits of a rising marketplace.

The above scenario sounds amazing!  It sounds so simple and no doubt you have probably heard many stories in Canada about flipping a house in a year and doubling your money, or maybe even tripling it depending on how much you leveraged.   Realtors and developers market on this idea, because it is so simple to execute and everything seems risk free.

Friends in the United States might have a different story to tell.  Those that bought at the peak of the housing market may actually find themselves in a situation where selling their home might even mean that you still owe money to the bank.  This is how leverage can hurt you.

If you use the similar scenario where you put a down payment of $20k on a condominium bought at $300k.  Since you are leveraged 15:1.  A 6.7% drop in the price of the home would wipe out your entire down payment.  Even a simple 1% drop on the price of the house would mean you would lose $3000 of your original $20k down payment.  That’s a staggering 15%!

Using leverage and borrowing money can work both ways.  When things are going well, you will make a lot of money.  When things go bad, things can get really bad in a hurry.  The one greatest fear about leverage is that you can actually lose more than you initially put in.  This is why the bank is generally less likely to allow individuals to borrow money in order to invest in the stock markets.  With a house, the bank can always repossess it, even if it is worth less than the value than you borrowed.

Before deciding on how much money you want to borrow to make any large investment decisions, be aware that there are risks involved when taking out a lot of money to buy an investment that you cannot own outright with a cash purchase.  Risk is something that should always be factored in when making an investment decision.  Once you can understand what you are getting into, it makes it much more comfortable to justify your decision.  Banks and money lenders will not warn you of these dangers because they want your business and sometimes they are willing to take risks in order to make more profits.  When making your own decisions just be wary, sometimes when things are too good to be true, they are.

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One thought on “Leverage

  1. Pingback: Setting a Target « Financially Yours

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