A brief outline
Investing in real estate can be a costly journey, however for those who already own a property, the good news is that this can be leveraged to purchase an investment property. This is a wealth building strategy used by many real estate investors who are strategically using the equity they’ve already generated, to build wealth. We’ll take a closer look at how to leverage one property to buy another.
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Real estate investing requires the right strategy for the right deal, and it’s vital for real estate investors to know which strategies they can use. One of these is called leverage. While it may sound like jargon, leverage can be a particularly useful tool in real estate investing, and even more so for investors who can leverage one property to buy another using their own money. Let’s discuss leverage in real estate; what it is, how to use it and the pros and cons of this investing strategy.
What is leverage in real estate investing?
Leverage is essentially when a real estate investor uses debt in the form of other people’s money, along with equity in the form of a down payment, to purchase an investment property and therefore increase the return on investment.
For example, if a property costs $200,000 and an investor puts down a $40,000 deposit, and takes the remaining $160,000 out as a loan, they’re already in a better financial position and potentially in a positive cash flow.
Home loans are almost all, by nature, a type of leverage for real estate investing, because buyers or investors only need to put down a fraction of the home’s actual market value, in order to take ownership of the property. For example, a 20% deposit and an 80% loan.
When we talk about using leverage as a strategy to build wealth, this is when property investors use the equity that they have built up in one property to buy additional investment properties. In other words, instead of using other people’s money to get a return on investment, they’re using their own money.
This strategy is great for investors who have already built up equity in one or more properties. It can be a useful method for wealth building, without having to rely on getting new loans approved and paying back other people’s money.
How to leverage one property to buy another
Step 1: Build up equity in the original property
Home equity is the share of the home that you own. You can work this out by taking the home’s market value and subtracting your current loan balance from it. Here are 5 ways to build equity in a property:
- Make larger mortgage payments or add on additional payments to decrease the size of your principal loan amount as quickly as possible. Each time you have extra money you can also add this towards your mortgage and you’ll be able to build equity faster.
- A big initial down payment is one of the quickest and best ways to build equity on a home. It means that you’ll be starting ahead, and you’ll also avoid having to pay PMI (private mortgage insurance) each month.
- Make improvements to the home to increase its value. This will mean that the home is valued at more than you paid for it, by the time you sell it. The idea is to pick the projects that will lead to the best return on investment and raise the home’s value the most.
- Switch to a shorter loan term so that you can pay less interest and pay off the mortgage quicker. This will increase your monthly payments however you’ll also be building more equity each month at a faster rate.
Step 2: Leverage that equity to purchase another property
Once you have built up equity in a property, you can then use this equity to purchase other properties and continue your real estate investing journey, using one of the following methods:
- Home Equity Loan
A home equity loan allows you to take out a lump sum from the equity you’ve built up in a property already. This is then repaid over a period of time in monthly installments, usually with a fixed interest rate. You can use this lump sum to put a large down payment on your next investment property.
Another way to use your home equity is to get a Home Equity Line of Credit (HELOC). This is a line of credit that is extended to you, based on your home equity. Similar to a credit card, you can use this as and when you need it, which is useful for buying another property and making improvements to it. HELOCs typically have variable interest rates, but fixed interest rates are an option. You’ll also be paying back the amount you’ve spent, along with interest.
- Cash-out refinance
A cash-out refinance allows you to replace your current mortgage with a larger one and access the difference between the loans as cash. Investors can then use this as a large deposit on another property, thereby tapping into their current property equity in order to purchase another one. This money is not taxed and there are no restrictions on how you use it.
Step 3: Apply for the loan
Once you’ve worked out which option is best for your personal circumstances, you can apply for the appropriate loan. The terms should be the best for your investing strategy for the long term. Once you’ve applied for the loan, the lender will likely order an appraisal to determine property values.
Step 4: Close on the loan
Once the lender has underwritten the loan, you should go through the loan terms carefully to make sure that they are the best terms for you. Then you can sign on the dotted line and get to purchasing your investment property.
Benefits of using leverage to expand real estate investment portfolio
1. Pay off debt quicker
Leveraging one property to pay off another, means that you’re using equity that you have already contributed to a property, in order to gain another resource that will assist with paying off your debt. When it comes to real estate, debt isn’t all bad because property appreciates in value over time. So, taking out a loan can be both useful and necessary, and it is likely to be paid back with money leftover in time.
Real estate is also an income-generating investment, which means that any properties that are purchased can be looked at as assets to help you pay off your debt. In other words, buying more properties isn’t just adding to your debt, but it’s also adding to your resources.
2. Take advantage of housing markets
Using one property to leverage the purchase of another can be a great tool for investors who are looking to take advantage of housing markets that are on the up. Getting into a market at the right time is crucial because it can lead to major profits as home prices increase at a rapid rate.
Being able to use the equity in your current property to get into a market that’s on the rise can be an important way to build wealth. It can also work the opposite way, if you were to purchase a property in a market that is falling and wait until the market rises again.
3. Debt consolidation
When you’re expanding your property portfolio, having all your debt in one place can be useful. For example, taking a home equity loan or refinancing your home in order to purchase another property, means that you’ll have all your debt for both properties in once place. This typically means that you’ll get better interest rates than other loans such as personal loans, and therefore save yourself money.
4. Increased buying power
When you use home equity to purchase another property, your buying power is increased because you’ll be able to make a larger down payment or even cover the full cost of the home. This means that you’re essentially a cash buyer, or at least a serious buyer with a large amount to put down on the home. This gives you a better chance at securing a home amidst stiff competition.
5. Approval is easier
The chance of being approved for a loan that includes using your current home equity is higher than the chance of approval on a new loan. Which makes this an easier option for those who already have a home loan with a decent amount of equity in it. It may even be a quicker option too, because the lender will already have a lot of the information they’d require from you, unlike new loan applications that are being done from scratch.
Risks of using real estate leverage to buy investment property
1. Original property can be at risk
The property which you’re using to leverage the next property purchase could be put at risk if the deal goes south or you run into financial difficulty and are struggling to make the repayments. If the original property you’re using to leverage your investment property is your primary residence, bear in mind that this could leave your home open to risk.
2. Closing costs
You’ll be on the hook for closing costs when you tap into your current home equity. These can range between 2% and 5% of the loan amount, which is a significant number to fork out. So be prepared to pay these costs, as well as any other costs that arise.
3. Larger total cost
You can end up paying more in total for using home equity. This is because interest rates for home equity loans can be higher than regular mortgages, and this means that over time you’ll end up paying more for the loan.
4. Multiple mortgage payments
If you use the equity in your current home to finance the purchase of your investment property, you may still need another loan to cover the difference. This can lead to more than one mortgage payment each month, which can be confusing and costly, with various payments and interest rates.
Final Thoughts: Should you use your home equity to purchase a rental property?
Purchasing an investment property is a great way to build wealth, particularly through an income-generating property like a rental. Using your current home equity to purchase a rental property is essentially a purchase that will be an asset and a resource to generate wealth and pay off the debt that you’ve incurred. Which makes this a good option for real estate investors, however, as with any big decision, it’s important to weight the pros and cons, and investigate other financing options, before making a final decision.