What Is Leverage In Property? Explained ✅

In the world of UK property investing and buy-to-let investing, leverage refers to using borrowed funds, typically through a mortgage, to finance a property investment.

It involves using a smaller amount of your own money and a larger amount of borrowed money to increase the potential return on investment.

But this can also increase the risks too.

Let’s break it down.

We made the video below which covers how leverage works with property investments. It covers the same points as this post with examples.

It’s less than 10 minutes, so give it a watch.

Table of Contents

How Does Leverage Work in Property?

In property investing leverage works as follows.

When you buy a property you’re faced with two main options…

You either buy in cash or buy with a mortgage.

If you buy in cash, you’re not using leverage.

But if you use a mortgage you are using leverage

This is because you are borrowing other people’s money (the bank’s) to purchase the asset.

But isn’t debt a bad thing?

Well not necessarily.

Let’s get into the benefits of using leverage.

Benefits of Leverage in Property Investing

Own More Assets With The Same Money

By using leverage, investors can control a larger asset value with a relatively smaller amount of their own capital.

This allows you to diversify your investment portfolio and potentially increase overall returns.

For example:

In the buy-to-let investing world, people generally use 25% deposits for buy-to-let mortgages.

This means you only need £25,000 as a deposit for a £100,000 house.

So if you had £100,000 in cash you could put down four deposits for four different £100,000 houses instead of just purchasing one single £100,000 property.

Amplifying Returns

If the property value increases, the return on the investor’s capital is magnified because they are earning a return on the total property value, not just the portion they personally financed.

For example, if the property goes up by 30% from £100,000 to £130,000 then that’s a 30% ROI if you bought in cash.

However, if you bought with a mortgage you probably only put down about £30,000 (25% deposit + fees).

So your return ends up being based on the money you put down which is only £30,000.

So your return on investment is more like 100% instead of 30%!

Inflation Erodes The Mortgage

Inflation is a silent killer of wealth, but only if you don’t know how to use it for your own gain.

Over time inflation will erode the value of money.

But this also means that it erodes the ‘real value’ of debt too.

And mortgages are debts.

This means that the value of your mortgage is being eroded over time through inflation so it ACTUALLY makes you better off compared to the average Joe.

Watch this video below to understand inflation in the context of UK property investment.

Time Is On Your Side

When using leverage, remember that you only need 25% of the property value as a deposit when using a buy-to-let mortgage.

So you only have to save ¼ of the amount of money you would need if you bought in cash.

So if it was going to take you 8 years to save for a property to buy in cash, then it would only take you 2 years if you use a buy-to-let mortgage instead.

In that 6-year time difference, you would own the asset, making use of rental income and potential capital gains as house prices trend upwards in the long run in the UK.

On top of this, if prices kept going up in those 6 years, then the initial 8 years it should have taken you to save to buy the property might turn out to be 10,12 or 13 years instead.

This is because you might only be able to save at the same rate, but property prices might keep increasing out of your reach.

But don’t forget that there are some disadvantages and risks of using leverage

Risks and Disadvantages of Using Leverage

Increased Risk of Loss

While leverage can amplify gains, it can also magnify losses.

If the property value decreases, the investor is still responsible for repaying the full amount of the loan.

Whereas if you were using cash there’s no loan to repay.

Negative Equity

If the housing market turns sour and drops a lot then you could find yourself in negative equity.

Negative equity is a situation when the remaining mortgage amount is more than the value of the house.

For example, if you have 25% equity but the property drops 30% in value then you’re in negative equity.

In this scenario, you’re normally unable to sell the house as that would be against the terms of the mortgage.

On its own negative equity isn’t a problem, but in certain scenarios where you NEED to sell, it can be a big problem.

Interest Rate Risk

Changes in interest rates can affect the cost of borrowing, potentially impacting the affordability of mortgage repayments and the overall profitability of the investment.

This is one of the main risks of using leverage in property.

If interest rates go up from around 2.5% to closer to 7% then the cost of mortgage interest payments would almost triple.

This would mean that your cash flow is at risk and you might even find yourself in negative cash flow if you are in a particularly low-yield area.

If you don’t have savings or other ways to subsidise these costs then you may need to sell the property.

If this situation arises at the same time as being in negative equity then you’re pretty much screwed.

On the other hand, if you bought the house in cash then any changes in interest rates do not affect your cash flow.

Short-term Cash Flow vs Long-term Gains

As mentioned above, when using leverage you’re at the peril of interest rate changes but when using cash they don’t affect you.

Even when interest rates are constant you would be making more cashflow per month if you bought the house in cash.

This is because there’s simply no mortgage interest payment to make and these always take up the largest portion of rental profits.

Other costs like maintenance and management tend to be smaller fractions of total rental revenue.

So investors need to manage the risk of having short-term cash flow for the sake of the longer-term gains that we mentioned earlier.