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.