fbpx

The Dangers of Leverage in Real Estate Investing

Leverage - its misunderstood, often abused and commonly used in real estate investing sales pitches. Here is everything you need to know and how you can avoid the biggest dangers of leverage.

What is Leverage? 

First we have to take a step back. What is money? Money is essentially a unit of value that purchases others “labour and resources”.

Generally speaking, over time these units (Canadian Dollars etc.) lose value and purchase less labour and resources (inflation).

We generally earn money through our labour and the management of resources under our control (think businesses, stocks, real estate etc.).

We can use this earning potential to convince others (lenders) to advance us money against our future earning potential. This advance or debt comes with an expectation to be paid back along with a premium (interest).

Essentially, leverage is debt and it is an advance on our contribution of labour and resources (in the form of money) in exchange for the promise of returning the money along with an interest cost at a future date.

What is Bad Debt?

For many the concept of debt is used to reach the “rewards” of our labour faster. This often creates a cycle of instant gratification followed by months or years toiling to pay off the debt. This is often referred to as “bad debt”.

Even worse is when debt is used to live a lifestyle beyond what can be supported by an individual’s earnings.

Imagine a Canadian that earns $100,000 per year and they live a lifestyle that costs them $80,547 per year.

This individual lives in British Columbia, has a gross income of $100,000 and after taxes keeps $75,024. They then are required to contribute $3,499.80 towards the Canadian Pension Plan followed by employment insurance at $952.74 for the year.

After all of this they are left with $70,571.26. For brevity’s sake I will stop here and ignore costs such as RRSP/Pension contributions, benefit costs, union dues etc..

This individual lacks financial awareness and does not track their spending well. They know they earn $100,000 and feel their spending is well below that but on some months they leave a balance on their credit card at 12.5% interest.

At the end of the year they have spent $9,976 more than was earned. In addition to this they have roughly spent an extra $591.86 in interest on their credit card. Leaving them with a total debt of $10,567.86.

They continue this cycle for three years. At first they justified or excused the debt in different ways but eventually realized there was a major problem.

They now owe $36,086.94 and it is a good thing they caught it after three years. If they would have continued down this path they would have owed $51,433 the fourth year, $68,811 the fifth year and $88,491 the sixth year.

As you can see over spending and debt can spiral completely out of control very quickly!

Remember this individual is only over spending by $9,976 per year yet could find themselves nearly $90,000 in debt by year six. It could be even worse! We are looking at 12.5% interest. If their credit card was at 22% interest they could owe $122,284 after six years. At 28% it would be $151,884.

A Fork in the Road

Fortunately it was only three years before this individual realized there was an issue and took action to fix it. They owe $36,086 at 12.5% interest and it’s time to make changes.

The first step they need to take is to stop things from getting worse. Not only do they need to reduce the cost of their lifestyle by nearly 12.4% (stop spending the extra $9976) but they also need to cut an additional 5.5% ($4550 in interest).

In order to stop things from getting worse they will need to bring their cost of living down from $80,547 to $66,021. This 18% reduction in their spending means they need to cut their monthly costs by $1210 to simply tread water.

To escape the debt in five years they will need to reduce the cost of their lifestyle by 25% or $16,432 per month. This would mean paying $811 per month towards the debts and eliminating the overspending.

Working More to Chase Bad Debt

For many, cutting costs by nearly 25% is simply not possible. The next logical step is to make more money but this is easier said than done.

To get out of debt in five years without a reduction in lifestyle this individual would need to make an extra $31,000 per year.

As your income increases from $100,000 to $131,000 your marginal tax rate rises from 31% up to 40.7%. 

Other Possibilities

Other options would be a blend of cutting back spending, earning more or reducing the interest cost on the loan. There are dozen of combinations to this solution. If you need help working it out reach out to a professional who can help.

If none of the solutions above are possible and there is no possibility of help from family the next is likely a consumer proposal or bankruptcy. 

I wanted to take the time to write this article because it is scary how destructive bad debts can be. In a relatively short period of time, often during periods of high stress, we can find ourselves in situations that can take years to dig out of.

Whether it is large debts or smaller debts held for long periods of time remember that bad debts can substantially reduce what we get over our lifetimes.

Find out more

As mortgage brokers we are on your team. Our job is to understand your needs, plans and wants in order to understand your mortgage needs. We then look at a number of lenders to find the best products and solutions for you.

During our time in the industry we have learned a number of tips and tricks to help you save money and to pay of your mortgage faster.

If you have any questions or would like a customized mortgage plan let us know!

You might also enjoy

What is Reverse Amortization?

Unfortunately, we have been seeing these reverse amortization situations occurring more and more frequently so let’s examine the scenarios where it happens and discuss what can be done about it.