Many investors choose to diversify their portfolio with real estate, which has provided consistent returns of about 5% per year in most parts of the country. Real estate also has income generation potential as well — no matter if you’re renting out the property or using your DIY skills to “flip” and sell the home, there are many ways to make money with real estate.
Unfortunately, real estate isn’t cheap — and most investors don’t have $200,000 or more to purchase the home they’re looking for outright. Using debt as leverage is a common strategy to invest in real estate with less money down. Our guide to leveraged real estate investing will help you learn more and decide if using leverage is right for your needs.
What is Leverage in Real Estate?
At its most basic level, leverage is using something that you have in order to access more money from investors or investing institutions (like banks). The most common way to use leverage in real estate is by leveraging debt and a down payment to buy a home.
When most people buy a property, they don’t pay for the entire home in cash. Instead, they bring a small percentage of the final selling price in the form of a down payment and borrow the remaining balance through a mortgage loan. When the bank gives you a loan, you’re leveraging your debt (usually around 80% of the balance of the property) to gain access to 100% of the home. In return, the bank includes a clause in your contract called a “lien” that gives them the right to seize your property if you fail to make payments on your loan. The bank will also charge an annual percentage of interest on your loan, which you must pay back in addition to your premium.
Leverage can be an excellent tool that you can use to gain access to a property that you cannot afford outright. However, too much leverage can work against you. If housing prices decrease in your area, for example, your home could become worth less than what debt you originally took out when you got your mortgage loan. Owing more money than your home is worth is called “being underwater” on your mortgage loan.
How Does it Work?
To use leverage to purchase a property, you’ll need to apply for a mortgage loan through a bank or an online lending service. First, find a home that you’re interested in purchasing and save for a down payment. Down payments are usually calculated as a percentage of the final selling price of the home. For example, if you were buying a home for $150,000 with a 20% down payment, you’d bring $30,000 to closing. The lender would finance the remaining $120,000 through your mortgage loan.
The percentage that you’ll need for a down payment will vary depending on the type of property you’re buying and how you plan to use it. If you’re buying a home in a rural area, for example, and you plan to live in it as your full-time residence, you may be able to use a USDA loan to purchase the property with 0% down. However, if you plan on using the property as an investment property to rent out, your lender might require a down payment of up to 25%.
For conventional loans, most borrowers bring 20% down to avoid paying for private mortgage insurance.
After you have your down payment, you’ll apply for a loan through your lender’s specific process. In addition to your down payment, your lender will also consider the following factors when determining if you qualify for a mortgage and your interest rate:
- Your credit score: If you have a higher credit score, you’re statistically less likely to fall behind on your mortgage loan. A higher credit score allows lenders to extend more favorable interest rates to you because you’re a less risky candidate for a loan.
- Your debt-to-income (DTI) ratio: Your lender needs to know that you have enough income to cover your loan payments. If you have additional debt besides what you’ll owe on your home loan (like a student loan debt or credit card debt) you’re more likely to fall behind on payment. This will cause you to pay more in interest.
- Your experience as a landlord: First-time landlords are more likely to fall behind on payments when compared to those who already own rental properties. If you’re buying a rental property, your experience as a manager or landlord will come into play when calculating your interest rates.
After you’re approved for a mortgage loan, your lender will send you a document called a Closing Disclosure that outlines the terms of your loan. You’ll be responsible for bringing your down payment to closing. At closing, your down payment acts as leverage — the seller gives you access to the property you’re buying, while the lender provides your buying with the remainder of the agreed-upon selling price. In return, you retain full control of that property as long as you continue to make your mortgage payments.
Real Estate Leverage Example
Imagine that you have saved up $100,000 to buy a small starter home. You have 2 options: You can purchase Property A in total for $100,000 in cash or you can use your $100,000 as a 40% down payment to purchase Property B for $250,000.
Real estate in the U.S. has traditionally produced an annual appreciation of about 5%. If you purchase Property A, in 1 year you will have a net worth of about $105,000, assuming the property increases in value by 5%. If you purchase Property B, you’ll have a net worth of $262,500 assuming the same 5% return. This is an example of how you can leverage a smaller amount of cash to multiply your returns through appreciation of real estate.
Best Real Estate Investment Platforms
Buying a property outright is among the many methods you can use to diversify through real estate. If you prefer to invest through a real estate platform, consider a few of our favorite options below.
- Best ForAccredited Investors
Must be accredited investing a minimum of $25,000.
- Best ForBeginner real estate investors
- Best ForNon-accredited Investors
- Best ForSmall Account Real Estate Investing
- Best ForCommercial Real Estate Investors
Adding Real Estate Investments to your Portfolio
If you’re looking for an easier way to add real estate investments to your portfolio, you might want to consider purchasing stock in a real estate investment trust (REIT). A REIT is a company that owns real estate or real estate debt and returns a large percentage of its taxable income to shareholders in the form of dividends. REITs offer a hands-off real estate opportunity for investors who don’t want to worry about choosing a property or becoming a landlord. You can learn more about a few of the most popular REITs here.
Accelerate Your Wealth
Arrived Homes allows retail investors to buy shares of individual rental properties for as little as $100. Arrived Homes acquires properties in some of the fastest-growing rental markets in the country, then sells shares to individual investors who simply collect passive income while waiting for the property to appreciate in value over 5 to 7 years. When the time is right, Arrived Homes sells the property so investors can cash in on the equity they've gained over time. Offerings are available to non-accredited investors. Sign up for an account on Arrived Homes to browse available properties and add real estate to your portfolio today.