Leverage in the context of Real Estate means "borrowing money" and derives from the word "lever" which can be used to create a tremendous amount of force. How does leverage work in real estate?
Let's assume you purchase a home for $400K with 20% down payment ($80K) and the bank loans you the remaining 80% ($320K). The word lever, " leverage" is appropriate because, like the strength you gain by using a lever, you have gained more purchasing power by borrowing money. You essentially buy a $400K asset for just $80K. Of course, now you have to repay the bank, but here is where the power of leverage kicks in.
Let's assume that San Luis real estate continues on the same trajectory it has been on for the past 100 years and it gains in value 2% over the rate of inflation (this is the average of all the bubbles and recessions during that time frame). So just by living in your home and not including any improvements you may make, your investment creates $8K ($400K x 2%) of wealth in the first year alone. When measured against the original down payment, that's a 10% return on your cash investment ($8K/$80K = 10%) which is pretty hard to find these days.
Now, imagine that you live in your SLO home for 20 years, through the magic of interest compounding at an annual rate 2% that the same $8K will turn in to $194,379. After 30 years, the gain would be $324,545 plus, by then, you would have probably paid off the original principal balance.
All of this is made possible by leverage, which is the borrowing of money to make the purchase of a home possible. Of course, we all got carried away with the use of excessive leverage during the bubble, but now may be a great time to revisit the concept. You can continue to track what the market here in San Luis Obispo is doing by watching the numbers. But your best bet is to find a house that you will be happy in, make a significant down payment (at least 20%) and let the power of leverage and compound interest work for you.
Despite what the media says, real estate is still the greatest avenue towards life long wealth. News papers, media, and politicians are on the bandwagon to talk about the horrible housing market. Talks about a mortgage crisis and meltdowns are just a piece to what is truly happening in real estate today. They publicize the negative for their own gain to sell newspapers and skew the true perspective. The truth is that 30% of homes in the U.S. are owned free and clear. The media never talks about this. The majority of homes for sale are not Foreclosures or Short Sales. Bad news is something to talk about create fear and despair. Don't let them stop you from pursuing a future investment opportunity. The fact is the media has been doing this to the real estate market for decades.
Some quotes from our infamous media:
"The goal of owning a home seems to be getting beyond the reach of more and more Americans. The typical new house costs $28,000 dollars."
- Business Week 1969
"Housing experts predict price rises in the future won't be that great. The median price of a home today is approaching $50,000 dollars.
- National Business Review, New England 1977
"The golden age of risk free run ups in home prices is gone."
- Money Magazine 1985
"A home is where the bad investment is!"
- San Francisco Examiner 1996
I don't know about you, but I wish I had invested in real estate in San Francisco in 1996.:)
Shoot me an email to find out more how the power of leverage can work for you!
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Traci Fergsuon
805-235-6396
traci@traciferguson.com
