Understanding Leverage?
It seems the key concept to successful real estate investment lies in understanding principle of leverage.
I can not form an intuitive explanation for why the longer the loan term, the greater the return on your money? I suppose if you could borrow money at 5% and invest it in something in 10% then you would want to drag it on as long as possible, no? But doesn't all the interest hurt you compared to paying everything off quickly?
Thanks!
You would have to think about the interest you are paying as the cost to carry the leverage. You are, in essence, controlling 100% of an asset for only the cost of a small percentage of its value.
In the case of REI, the asset generates a cash flow in the form of rental payments. The ROI for the rental income component of this type of investment is very sensitive to the financing. For example, the monthly payment on a 30 year product will require less cash to cover than a 20 or 15 year product... lower cost to carry makes room for more profit margin on a monthly basis.
Over time, rents will increase and so will profit margins. Yes, it will take longer to pay down the mortgage on a 30 year, but if we consider a five year investment window, you ultimately tied up less cash to carry the asset by choosing a longer term mortgage which means any appreciation in the value of the underlying asset over that five year period will boost your effective ROI.
Does this make sense?
[ Edited by galgano on Date 08/02/2004 ]
The basis of leverage investing is to have more capital at work than you have in your own account. So you borrow relatively low-rate money (i.e. bank money) and invest it where it will return higher rates, preferably because you manage it more actively.
You have to keep in mind, however, that leverage comes with its own risks. It is, as my accouting professor used to say, a two edged sword. It multiplies the ROI on your capital. When the ROI is positive that is a good thing. When it is negative it is not.
[ Edited by commercialking on Date 08/13/2004 ]