Don’t let the math scare you; leverage is pretty simple.
Let’s say you are comparing two possible investments. You could invest $50,000 into a high-yield CD, or you could buy a $250,000 home with 20 percent down, and get a first mortgage for $200,000. We assume there are the loan and purchase costs of $2,500 on top of the down payment. To make the example simple, we’ll assume the mortgage is interest-only. You’ll keep the property for seven years and then sell it. How do the two investment opportunities compare?
Let’s assume that the CD will pay 3 percent (that’s rare today, but let’s be generous) and your home will appreciate at 3 percent per year. Looking at the example, you can see your investment in the CD is worth $61,494 after seven years, a profit of $11,494. Not bad.
But look at what happened to your initial investment in real estate! At 3 percent per year appreciation, your home is now worth $307,468! You still owe $200,000, so you have to pay that off. You’ll net $107,468, which gives you a tidy net profit of $54,968, which turns out to be a 10.78 percent annualized return on your investment.
How did 3 percent appreciation turn into a 10.78 percent profit? You were earning money on the mortgage company’s money. Leverage.
This example is simplified to illustrate the principle. It ignores how your mortgage payment compares with the rent you would otherwise be paying, sales costs, maintenance costs, tax advantages of owning real estate, pay-down of principal as you make payments and the emotional satisfaction of owning your own home. Some of these factors would decrease your return, others would increase it. But if all of these were factored in, the result would be similar.
There are non-financial reasons to buy (or not buy) a home, too, that you should consider. However, if you have held the belief that your investment in your home will only yield a return equal to inflation, please reconsider, as you are missing out on one of the most powerful investment tools there is – leveraging other people’s money.