Leveraging Equity: The Smart Investor’s Key To Building Wealth

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Are you looking to expand your real estate investment portfolio? Let’s discuss leveraging equity, which is one of the best ways to invest in real estate. What is leverage, how does it work, and when should you use it? We’ll be deep-diving into all of these questions, as well as exploring situations where leveraging equity may not be the best option for you. 

What is Equity In a Home?

Before digging into leverage, though, it’s important to understand what home equity is—because that is what you’ll be leveraging to increase your real estate portfolio. In short, home equity is the value of a house minus the outstanding mortgage on the property. If your property is worth $250,000 and you owe $100,000 on the mortgage, you have $150,000 in equity. The more equity you have, the higher your return on investment (ROI).

Real estate investors often use leverage to buy more than one property. That’s because the more real estate leverage an investor employs, the more they can build wealth. Leveraging equity provides other benefits to real estate investors, such as diversifying their investments. Investing in both commercial and residential real estate, for instance, can be a boon during a recession.

Now that you understand equity, let’s talk more about leverage.

What does leveraging equity mean in real estate? 

You may be asking yourself, “What is leveraging equity in real estate?” In simple terms, real estate leverage is when you use debt to expand your potential return on investment.

Basically, it means you borrow money from a lender to purchase a property.

By leveraging equity, you can afford more real estate investments than you would by using your own money. By using a lender, you can now use leverage to purchase multiple investment properties.

How does leveraging equity work in real estate?

Let’s say you want to leverage your primary residence to start a real estate empire. Your lender allows you to borrow up to 80% of the home’s worth through a home equity line of credit (HELOC).

In this scenario, you have a $250,000 home, so you can borrow up to $200,000. Subtract the $100,000 you currently owe on the mortgage, and you have $100,000 to invest. You could use this to purchase a rental property outright.

Congratulations—you just leveraged property to increase your portfolio.

If the value of your $100,000 investment property goes up by 5% in a year, it will be worth $105,000. Thus, your net worth will have increased by $5,000.

Leveraging equity lets you increase your return. Instead of buying a $100,000 property outright, you could use that money as a 20% down payment for a $500,000 property. After 12 months, let’s say the value goes up by 5%. Your real estate investment is now worth $525,000, and your net worth has increased by $25,000. That’s $20,000 more than if you had purchased the $100,000 property outright.

Boom: The power of leverage.

Why use leverage in real estate?

A common myth is that all debt is bad debt. When you typically think about debt, you don’t get a warm and fuzzy feeling, right? You probably have a negative reaction and think about debt collectors. However, real estate debt is just the opposite: instead of a loss for you, it’s actually a gain.

Managing equity properly can be a positive lever, especially if used to compound wealth rather than consumption. Having equity in your property doesn’t necessarily enhance your net worth. However, accessing that equity can, especially if used to accelerate your other resources to cover your debts.

This leverage form of debt works to your advantage in a rising market. If you have the time, finances, and patience to wait out a falling market, you will be rewarded with a successful investment when real estate markets are strong.

Essentially, you can put little to no money down and generate an increase on your investment return while waiting out a crashing market.

How to Access Leverage

The easiest way to access leverage is by taking out a mortgage. If you have a 20% down payment for a house and get approved for a mortgage, you own 100% of the property and can use the 80% you got through the loan as leverage. 

But even if you don’t have the money for a down payment, you may still be able to access real estate leverage. You can do this by going into a partnership with other budding investors who may be able to provide part or all of the down payment needed in order to access equity. 

Finally, in some cases, the seller of a property may be able to cover a part of the purchase price, or the fees associated with the sale, which would reduce the burden on you as an investment buyer.

The Benefits of Leveraging Equity

People are familiar with the concept of investing in the stock market to generate a return. If you invest $100,000 in the stock market, you are paying that money in cash upfront. To double your money, the stock has to increase by 100%.

However, a real estate investor with a goal of leveraging equity to build wealth may choose to put down only $20,000 on a $100,000 investment. That house only has to appreciate by 20% for you as the investor to double your money.

Everyone starts in different places. If you have never bought a house, buying your first with a value-add is an effective way to get started. (A “value-add” is when you work to increase the property value – usually through renovation.) You learn the buying process, and you get to make your first purchase with an investor mindset. If you already own a house, then you may have equity in it, or you may be able to refinance to get some of the cash out at a low-interest rate.

If you have a house with equity, but you can’t access the equity—for example, because you haven’t reached the 20% minimum equity needed for most cash-out refinances—now might be the best time to sell. Many markets are currently inflated, and if you’ve been living in the house for two years, the gains are tax-free. From equity to selling to HELOCs, there are lots of options available. Make sure you take the time to consider them all.

If you have equity that you can borrow against, then a HELOC acts like a credit card against your house. It uses the existing equity you have in your house, which allows you to use the funds at your discretion. And just like a credit card, you don’t owe anything until you deploy the capital.HELOCs are a highly recommended strategy for buying more property.

Along with increasing your potential ROI, there are other reasons to consider leveraging real estate.

• Increased monthly cash flow: You might have enough cash on hand to buy one real estate investment outright. Through leverage, though, you can buy more properties and generate more rental income.
• Increased tax deductions: Real estate investors can often deduct mortgage payments and rental property improvement expenses from their taxes. The more real estate investments you have, the more you can deduct.
• Diversity decreases risk: Leverage enables you to buy more rental properties—ideally in different classes—which can insulate you from the dangers of real estate investing.

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The Best Way to Leverage Equity in Your Home

You now know how leveraging equity works and how you can tap into this way of building wealth. So far so good. But why stop there? Rather than just leveraging equity you’ve accessed through a home purchase, you can increase your leverage, making the house work harder for you to build you wealth not just provide a roof over your head. Here are the best ways to do this.

Home improvements

One of the best ways to leverage equity in your home is to finance upgrades and remodels that will add value to your home. One of the benefits of leveraging equity this way is that you usually can get your mortgage interest back. Note that mortgage interest isn’t tax-deductible if you leverage equity for other purposes. 

When leveraging equity to finance a home improvement, you’ll need to make sure you choose your project wisely as not all of them give good ROIs. Do your research: if the improvement isn’t structurally necessary, will it give you enough of a return?  

Real estate investing 

Another great way to leverage equity is by using the equity you have in your home to buy an investment property. To do this, you’ll need to take out a home equity loan or a HELOC, with your main home used as collateral. The rental payments you then get for your investment property will need to cover the mortgage, property taxes, and all other expenses associated with your investment. 

Once you’ve leveraged equity this way once, you can do it again, provided your current investment property isn’t losing you money.

Debt consolidation

Yes, you can use real estate leverage to consolidate debt. Why take on more debt to pay off your debts? It’s all about interest rates. Home equity loan interest rates are typically much, much lower than your typical credit card rates. We’re talking rates at around 5% vs those at around 20%. If you can’t seem to be able to pay off your credit card debts but have home equity, leverage it! 

Be careful, though: this way of leveraging equity should only be used in conjunction with a meaningful plan to cut spending, or you’ll find yourself in an even worse position several months down the line, having to pay off both your home equity loan and yet more credit card debt. 

Refinancing

You don’t have to invest in properties in order to generate wealth through leveraging equity. Often, simply remortgaging can make you better off by reducing the total amount you’ll be making in loan repayments. When you refinance, you can significantly reduce the total amount of interest you’ll be paying over the lifetime of your mortgage. And, if you have 20% equity in your home or more, you can also refinance on better terms – for instance, you’ll no longer need to make private mortgage insurance payments, or you can shorten the term of your mortgage, which means that you’ll own your home outright sooner. 

Sell Your current home

For some of us, the smartest financial move will also be a geographical move. Selling your current home at a good price can open the door to greater financial independence by buying a house in a cheaper area with lower living expenses. Moreover, if you make a smart move from an expensive area to a cheaper one, you could have money left over that you could put into savings, a retirement fund, or (you’ve guessed it) toward an investment.

Paying off your medical bills

Once again, this one comes down to interest rates. If you’re planning to pay for your health care expenses with a credit card but own your own home, you should consider paying off the bill with a home equity loan. It will work out cheaper than being saddled by all that expensive credit card debt.

Funding your kids’ higher education

We don’t have to go too deep into this one. Everyone knows that paying for college isn’t cheap. Leveraging home equity can be a good way to finance your kids’ college tuition, and you don’t necessarily have to sell. YOu can do this by taking out a HELOC or doing a cash-out refinance. 

The Dangers of Leveraging Equity in Real Estate 

While leveraging real estate can be an excellent way to build wealth, it’s not risk-free. Before you decide to leverage equity, consider the following dangers that come with this practice.

Risk of foreclosure

When you leverage your real estate, keep in mind a lender will hold a lien, which is a mortgage or a deed of trust against your property. The lender thus has the power to foreclose on your property if you default on your loan, which means you would lose everything you invested into this property.

Lender terms

Decide carefully who you do business with.

When leveraging real estate, investors do not have consumer protection because real estate loans are considered business loans. You want to steer clear of any lenders who seem dishonest or unethical. High-interest rates are a red flag, as are unfair lender terms or hidden fees in the fine print of your contract.

Depreciation

What if the value of your property depreciates instead of rises? If this happens, you’ll owe more than your property’s worth. This is definitely not building wealth as you intended.

For example, let’s say the value of that $500,000 property goes down 5% in your first year of ownership. Your $100,000 investment is now worth $75,000, and your net worth has dropped $25,000.

If you bought a $100,000 house in an all-cash purchase, a 5% drop would decrease its value by $5,000. Yes, your net worth still decreased—but that’s better than losing $25,000.

Loss of rental income

Your finances can take another hit should rents fall alongside property values. Keep in mind that your rental properties’ value is directly based on what rates you can charge your tenants. Tenants will pay less in a decreasing and competitive market, which means your income decreases. If this happens, you may not have enough monthly income to make your mortgage payment, and you might take a loss on your investment if the situation does not improve quickly.

This is an example of over-leverage, which means you owe more on your loan than your monthly cash flow brings in. For instance, let’s say that you have two properties with monthly mortgages totaling $2,000. If your monthly rental income drops to $1,500, you’re now over-leveraged by $500 a month.

Of course, the more properties you leverage, the bigger the hit you’ll take. Leveraging more real estate can multiply your ROI through housing appreciation, but the inverse, a depreciation of assets, is true too. Your net worth falls if you own one depreciating property and obviously falls even faster the more depreciating properties you own.

Keeping in mind the risks, leveraging real estate to build wealth is still an excellent financial investment. By minimizing these dangers, you can potentially grow your net worth and your real estate investing business.

As the saying goes, there’s no reward without risk.

Be thorough in your due diligence. Check out an investment property carefully and the reputability of your lender. If the market is not headed in the direction you would like, be willing to wait for the market to go back up again.

The Cons of Leveraging Equity on Multiple Properties

An inexperienced real estate investor should probably avoid leveraging equity on multiple properties. That’s because one bad investment can cost you your whole real estate investment portfolio. How? Imagine you leveraged equity on one of your properties in order to generate the cash to fund your next investment. Then you did the same with your next property and so on. All your investment properties are connected financially. 

If one of your investment properties fails to generate rental income or falls significantly in value (to the point where you are in negative equity), or both, you won’t be able to generate the cash flow that supports the payments on the other properties. You could, in fact, lose your entire portfolio to foreclosure if this chain reaction happens.

Conclusion

When it comes to the real estate market, what goes down must eventually go back up. You may have to be a little extra patient when leveraging real estate to build wealth. But that doesn’t mean leveraging equity is a bad idea because the increased financial benefits tend to outweigh the risks in this type of investment.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.