The concept of financial leverage is fundamental to harnessing the power of capital on your road to financial freedom. Using hard money loans to acquire, renovate, and refinance real estate is the most accessible way to utilize leverage as a real estate investor.
Financial leverage may be a term you are familiar with, but how does it actually work in practice? Read on to see how hard money loans can begin to pave your way to real estate glory!
Shift your perspective: Debt is good.
The terms leverage and debt are often used interchangeably. Unfortunately, there is a commonly held generalization that "debt is bad." Most likely because in generations past, people could save their money and earn a decent return for doing so. In the meantime, their goal was to save for retirement, pay down all of their debt as fast as possible, and never need to borrow money for anything ever again. They passed this perspective onto their kids, who passed it on to their kids ad infinitum.
The problem with this perspective is the problem that's been inherent in our society for decades upon decades. A lack of financial literacy has been passed down from generation to generation. The wealthy were always using debt and utilizing it to create bigger and bigger opportunities for themselves. Leverage is the secret that was hiding in plain sight. With the advent of the internet and social media, the real estate investor community has grown exponentially and exposed people to financial concepts they would have otherwise been lacking. Any real estate millionaire will tell you-- debt is your friend-- when its power is harnessed responsibly.
How does leverage work?
Leverage works much like.... hmm... a lever! Imagine a seesaw, on one side is your return on investment and the other side is debt. As you add debt to one side the easier it is to raise the other side higher into the air. This is a very simple way to visualize the way debt moves your return on equity in varying degrees. Much like a seesaw, if you add a little debt, it will move the other side quite easily. Once you get it moving and add more force (debt) the seesaw is a powerful lever that will send the other side flying high into the air!
This is how leverage is used to increase your return on equity in an investment. Let's apply this concept to a hard money loan.
"Financial leverage is the advantage the rich have over the poor and middle class." – Robert Kiyosaki (click to see his qualifications)
Is a hard money loan a good idea?
Let's create two simple scenarios with two friends, Bobby NinetoFive and Larry Leverage.
Bobby NinetoFive buys a house to fix and flip for $100,000. The house needs $50,000 in repairs, and when it is all done, he sells it for $180,000. Bobby makes $30,000. It takes him six months.
Over the six-month time period, Bobby NinetoFive would make 20% on his own money.
($30,000 profit / $150,000 investment = 20% return)
Larry Leverage buys a house for $100,000. The house needs $50,000 in repairs. Larry uses a hard money fix and flip loan of $120,000 at 12% interest to buy the house and make repairs, using $30,000 of his own money as a down payment. It takes Larry 6 months to complete the project and his interest costed him $7,200. He also sells the house for $180,000.
Over the same six-month period Larry Leverage would make 80% on his own money.
($30,000 profit / ($30,000 investment + $7,200 interest) = 80% return)
Furthermore, since Larry still has money of his own left in his pocket he can do multiple projects at the same time, further increasing his returns. Additionally, he maintains liquidity instead of using all of his money at once. This is the power of hard money loans as tools to increase your return on equity. Much like the seesaw concept, Larry used a little bit of money on one side of a lever (the loan) to increase his rate of return.
Plan, Plan, Plan!
Using hard money loans to buy and flip real estate is a powerful tool when used properly. Leverage is powerful in increasing your returns but can also work to magnify your losses if the tool is not utilized correctly. Failure to plan for contingencies or analyze your deal correctly can be catastrophic when using hard money loans because there is an additional expense accruing every month. When these expenses are predictable and accounted for, they are simply part of your financial strategy. But if you lack a plan, over leverage yourself, and lack liquidity, you will be up the creek without a paddle.
Hard Money Loans are not hard to get!
Since hard money loans are approved based on the value of the underlying asset, anybody with a nose for a good deal and a 20%-30% down payment can buy into income producing assets. In the absence of an all-cash purchase, hard money loans are the easiest and quickest way to buy a property. Often times, a good deal is time sensitive so getting a loan or proof of funds to make an offer quickly is of the utmost importance. Investors cannot get bank preapprovals quickly because of the regulations and financial investigation required to do so. That is why using hard money loans to get deals and refinancing out of them is the gold standard of building a real estate portfolio. Eventually, once you've made so many magnified returns with hard money loans, you won't need them anymore!
Lever Up!
If you are interested in investing in real estate, fix and flip loans, or utilizing a buy and hold strategy, hard money loans will be among the most important tools you can use. Find out more about hard money lending online with Rochester's preferred private lender Webster Capital.
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