The Effect of Leverage on Returns AKA There IS a Time that more Debt is Good.
We’ve come to think of all debt as bad debt but there is a type of debt that is good debt – that is debt that you use to lower the amount of equity (cash) you make in an investment.
Let’s consider the situation of buying an investment property, like a house that you rent out to long term renters or short terms renters (VRBO or Airbnb). Let’s say the house is $400,000 and you think you can bring in $1,500 per month after all your expenses except for your mortgage interest.
You have two options. You can buy the property and put 25% down ($100,000) or you can buy the property and put 10% down ($40,000). Let’s assume you pay 3% interest on your mortgage if you put 25% down and 3.5% interest on the mortgage if you put 10% down (you’ll have to pay more interest to put less down because it is riskier for the bank).
You might say to yourself, “but I want the lower interest rate so I’m going to put more down”. In some cases that might be true, but let’s see what happens to your return on your investment.
The spreadsheet below shows the situation for both investments.
In the 25% down scenario you clear $7,500 in a year while in the 10% down scenario, you clear $7,200 in a year (this is not exactly true as you also have payments on the mortgage principal, but we’ll forget about that for now). In the 25% down scenario you clear $7,500 (because the interest rate is lower and you pay less interest).
So, it looks like you are better off going with the 25% down as you make more every year. But let’s see what happens when you compare the money you get out with the money you had to invest in the first place.
We all understand the concept of interest. If we put our money in the bank or any investment there is amount of return we get on that money that is in the form of interest. These days those numbers are pretty small in anything except the stock market. So, we make an investment (the money we put in the bank) and we get a return (the interest we get out).
The same holds true in this investment. In the first case you invested $100,000 (the investment) to get $7,500 (the return) and in the second you invested $40,000 to get a return of $7,200. The Return on Investment (ROI) is just the return divided by the investment. So, in the first 10% down case you have a return of $7,500 on an investment of $100,000 = 8% (good!). But in the second, you have a slightly smaller return of $7,200 on a much smaller investment of $40,000 = 18% (great!).
This ROI calculation is a great way of thinking about any investment you might make. For example, if you were thinking of investing in solar panels for your house and the upfront cost is $20,000 with an expected return of $1,000/year in reduced electricity cost, you can see your return on investment is 5% ($1,000/$20,000). So, if you had to borrow money on a line of credit secured to your house at 3%, this would be a very good investment.