Leverage is an investment term that describes the use of borrowed funds to control an asset; sometimes referred to as using other people’s money. Borrowed funds can affect the investment in your home positively.
For instance, if you had a $100,000 rental property, collected the rents and paid the expenses, and had $10,000 left, you would earn a 10% return (divide the $10,000 by the $100,000.) With no loan on the property, there is no leverage.
If you decided to get an 80% mortgage at 8%, you would owe an additional $6,400 in expenses leaving you only $3,600 net. However, your return would grow to 18% because your investment is now $20,000 in cash (divide the $3,600 by $20,000.)
Leverage, the use of borrowed funds, causes the return to increase in this example. While most people associate leverage with rental properties, it also applies to a home. The larger the mortgage, the more leverage you have. An FHA mortgage with a 3.5% down payment has more leverage than an 80% loan.
Assume we’re looking at a $295,000 purchase price with 3% closing costs and a 4.5% mortgage for 30 years with a five-year holding period. The following table shows the return based on different down payments and appreciation rates. The initial investment is the down payment plus closing costs. The equity build-up at the end of year five is the result of normal principal reduction and appreciation.
Another way to look at the 3.5% down payment example with 3% appreciation would be to say that a $10,325 down payment plus $8,850 in closing costs could grow into $82,482 of equity in a five-year period producing a 34% rate of return on the initial investment.
Estimate what your initial investment could grow to using this Rent vs. Own. If you need any help, let me know at (865) 588-3232 or shannon@FosterBolineGroup.
