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Whether you’re a new or experienced home buyer or real estate investor, there’s always more to learn about leverage. Because personal circumstances – as well as external factors – are always in flux, how you finance a deal today may be different than how you might have financed a deal 10 years ago or how you might finance a deal 10 years from now.
Though some of these variables may escape your control, you can take the reins of your real estate investment journey by learning how to use leverage to your advantage when structuring a deal.
Here are some essential guideposts.
Explore all of your options.
While a lender can provide more specific information, it’s helpful to know the basics about common leverage products.
Many people think they should choose a 15 or 30-year fixed-rate mortgage because it’s the traditional route. A fixed-rate mortgage can be a good fit for people who earn a regular paycheck on a relatively fixed salary. This is because a fixed-rate mortgage allows you to regularly pay down your principal investment at the same interest rate for the duration of the loan.
An adjustable-rate mortgage (ARM) offers a lower fixed interest rate for a period of time, after which the interest rate can be adjusted annually. You might select an ARM based on your individual risk tolerance and how long you plan to own a home. Very few people spend 30 years in one home; an ARM that guarantees lower interest rates for a number of years may be a good choice if you’re buying a home with future plans to size up.
Those who have rising incomes or who plan to receive large bonuses might select an interest-only mortgage, which is a 30-year fixed mortgage that requires interest-only payments at a fixed rate for a period of time. After the initial interest-only period, the loan’s principal and remaining interest are paid at an adjustable rate.
Get clear about interest vs. principal payments.
When evaluating the pros and cons of different mortgage products, you may want to use a mortgage calculator that breaks down the principal and interest payments of each option to get a clear idea of how each payment structure would align with your life goals.
In addition to understanding the terms of each loan, you also need to understand the flexibility of each term – such as payment structure – and how you might adjust terms to better meet your goals.
For example, you might want to pay down the principal of an interest-only loan during its fixed interest-only period in order to lower your monthly payment. If you have a fixed-rate mortgage, you may or may not be able to make large lump-sum payments toward the loan’s principal (known as “recasting”) in order to lower your monthly payments and total interest. Lean on your accountant (CPA) or financial advisor to map out how to best use leverage in your overall real estate investment strategy.
Know the value of a mortgage point.
Mortgage points can be purchased directly from a lender during closing in exchange for lower interest rates. One mortgage point equals one percent of your mortgage ($1,000 for every $100,000). Points generally become more valuable the longer you own a home, because it takes time to recoup the purchase price.
Because different lenders offer different terms and discount interest rates, using a mortgage point calculator can help you determine the length of this “break-even period” and how much money different point values might save on an investment.
Plan for the future.
When investing in the right home for right now, you should also plan for how a home will work for you in the future. Leverage is a wonderful tool as long as you don’t outleverage yourself. To ensure that you’re not putting too much leverage on a property, consider what you might be able to rent it for if you had to move out but did not want to sell.
Perform a basic rental survey using public information to compare your monthly mortgage payments to how much rent you could expect to collect. If you prefer to be more conservative when planning, you might allow for two months’ annual vacancy and a potential 20% decrease in the current rental market. You can adjust your plan based on your own personal risk tolerance.
If you plan to purchase an investment property, you may want to calculate its potential cash-on-cash return in advance. This is an easy calculation to check what your potential returns might be: the cash you collected on a property over 12 months, divided by the physical cash you have invested.
By using leverage to buy property with high return on investment (ROI), you may be able to leverage one real estate investment to finance another. Your CPA can help you factor in more detailed investment considerations that impact your returns, such as capital improvements, depreciation, taxes, etc.
It’s possible to defer paying taxes on the capital gains from selling one investment property in order to purchase another “like-kind” property through a 1031 exchange. Down the line, you may even consider investing through syndication, which is when multiple investors pool resources to invest more together than they could on their own.
You don’t need to be an expert to successfully invest in real estate, but you do need to know how to ask the right questions. Ask your real estate agent, lender, CPA or financial advisor to further explain leverage terms that seem vague or potentially risky, and make sure you’re utilizing all available tax write-offs.
Simply staying organized pays huge dividends. Keep a separate bank account for everything related to your home or investment, so you can clearly track expenses, including upgrades such as ADUs. Then, when you’re ready to sell one property and invest in another, you’ll have a neat little balance sheet and a wealth of experience to take with you.