Leverage is a term used a lot by property investors, but it is not fully understood by those new to buying properties to let. However, leverage is a term that describes the amount you can make over the amount you borrow. Leverage is the best way to maximise you return on investment, but it is not without its risks, and understanding them is the key to doing well in the property market.
Borrowing
Many people assume that buying a property for cash is going to be a far better investment than borrowing money. After all, with a cash payment you have no interest charges to pay, so everything you earn in rent is profit (minus expenses). However, this is not necessarily the case. For instance, if you buy a house for £200,000 and rent it out for £2,000 a month, you will earn £24,000 per year (minus expenses). This equates to 12% of your initial investment. However, if you borrow money to buy the same property, placing down a deposit of £40,000, you will earn the same £2,000 in rent. Of course, you will have to pay your loan repayments. However, with a 6% interest rate, plus the principal repayment, a £40,000 loan repayable over ten years will cost about £6,400 a year (£4000 principal plus £2,400 in interest), leaving you with about £17,600 from the annual rental payments. This may sound like a worse investment compared to the cash deal, but when you look at the percentages, rather than being 12% of your initial investment, £17,600 equates to a whopping 44%. This is why leverage represents such a good investment method for buying property.
Pitfalls
One mistake many people make when using leverage to make a property investment, is assuming the house price will continue to rise over the length of the loan. This may not be the case, and if you fail to anticipate a fall or stagnation in property prices, you may find yourself in negative equity, especially if you are planning on rising house prices to help pay off your loan.
Leverage is also risky if you fail to get tenants into your property. When you are not earning rent, you still have to make your loan repayments, which could get you into trouble if you don’t find tenants quickly. When using leverage, always ensure you plan for every eventuality. Buying the right property in the right location is key when it comes to a successful leverage investment.
Borrowing
As with any investment, getting the best deal is important for buying property using leverage. Always shop around for the best interest rates and ensure you take into account any fees and charges, especially if you are adding these to the loan amount, as this can reduce the yields you may make. In addition, make sure you have plenty of funds for servicing the property. You may have to do some building work or renovations before anybody can move in, so you need to ensure you can cover these costs, otherwise you may find yourself having invested in an empty house.
