What is Leverage?
“Leverage” results from using borrowed capital to fund investments and increase the potential return of your investment. Essentially, leverage helps you to get more for your money.
You purchase a property for £100,000 without leverage and over the time period you hold your investment, property market prices increase by 20%. This gives you a £20,000 return on investment, or 20%.
This time, you purchase the same property for £100,000, but you buy it with a mortgage, putting down a 25% deposit, so you spend £25,000 and you borrow £75,000. The same market changes occur and prices rise by 20%. This means the equity in your investment goes up by £20,000, providing you with a huge 80% return on your initial investment of £25,000.
Leverage also works well with inflation
Inflation refers to increases in prices and the decrease of the purchasing value of money (see Google for more!). Governments have Inflation targets that aim to maintain inflation at a rate of c.2%, although historically the actual rate of inflation has been closer to 3.5%.
Inflation reduces the ‘real value’ of money over time and because this process is still happening even when house prices are static, this means that if you have a mortgage on a property locked in from when you made the purchase, the actual value of that debt decreases over time due to inflation.
Further, if you purchase using interest only mortgages, you don’t even have to rely on the usual statistic of house prices doubling every 7 to 10 years, as inflation will help your investments along the way.
The effect of inflation also benefits your CASHFLOW! Year after year, inflation grows and so generally, do people’s wages and the rental value of your property. This means that, if you use leverage (say, an interest-only mortgage), the amount of debt stays the same but inflation is DEcreasing the value of that debt, whilst INcreasing the rental value of your property, so leaving property prices aside, the power of inflation, combined with leverage can make a significant difference to the performance of your property investments.
REMEMBER - All investment activity carries risk. The incorrect or over-use of leverage can expose you to significant financial risk. It is important to take advice from qualified professionals and ensure you understand all associated risks prior to investing.