Gearing up!

In four words

The word leverage always brings to my mind a mental picture of a frail old lady gardener, who, on finding a large rock in her carefully tended flower bed decides to get rid of it. She tries to grip it and lift it but to no avail. She tries to force it out of the ground with her bare hands but it won't budge. So finally she goes to the shed and chooses the strongest long-handled spade she owns, and tucking the blade under the rock, she presses down on the end, to find that with some pressure, she can slowly lift it into the air. Note the contrast between the lady and the stone. One is spindly, the other is heavy, but the force of the spade (and the length of the handle - not too long) enables her to lift a gargantuan weight into the air: something she definitely couldn't achieve by lifting it on her own.

Leveraging (or gearing as you might hear it called in the UK) is what in finance is equivalent to the action that the old lady takes by using a tool to raise something much more than she could alone. In property, you might not have much to begin with, but leveraging allows you to punch above your weight in terms of the finance you can access. Using other people's money (OPM) combined with your own, you have much greater purchasing power, and much greater possibilities of future income. In property investment terms it might look a bit like this:

Hilary Hopeful has been saving money for a rainy day but has decided that her savings are not really going anywhere. She has a total of £100,000 saved up. She decides after much consideration to buy a property to let so that she can have some income from her money, and as a bonus she might make some money long-term if the property rises in value over time. She finds a property for £100,000 and uses all her money to pay for it. She rents out the property for £500 per month. Therefore she has an income of £500 x 12 months = £6000 *. This counts as income, so she will have to declare it to the Inland Revenue, and if she has other earnings she will probably have to pay tax on the £6000.

Pauline Purposeful has also been working hard, saving for a rainy day and has saved £25,000 so far. She also has decided that money in the bank is next to useless and wants to get into property. She too sees a property for £100,000 which she makes an offer for and buys for £100,000. In Pauline's case though, she is using a mortgage to fund the other £75,000 which she hasn't got. So £25,000 of her money and £75,000 of someone else's money are together making the £100,000 she needs to buy the property.

She too rents out her property for £500 per month. However, she also has a mortgage to pay of £400 per month. Of which £200 is interest. She has an income therefore of  £500 x 12 months = £6000. She is able to claim the interest cost of the mortgage (£200 x12 = 2400) against her income. Therefore her income is reduced by £2400 to £3600.

You might think 'well I'd rather have more monthly income so I think I'll follow the example of Hilary Hopeful' . And yes, you could do this if the amount of income is your major priority. But lets look at the return on investment (another three letter acronym - remember I mentioned these much earlier in my blog?!) or ROI.

Hilary has invested £100,000 and is making £6,000 - in other words 6% return on investment.
Pauline has invested £25,000 and is making £3600 - in other words 14.4% return on investment.

Who is getting the highest return on their investment (ROI)?

(Wish that you had paid attention in 'O' level maths now?! -  I just wish they had taught this stuff in 'O' level maths!).

So you can see how actually Pauline is a more savvy investor. If she invested £100,000 in this way, by putting £25,000 in four properties, she would actually be getting £3600 x 4= £14,400. Much more income than Sylvia - simply by leveraging what she puts in more effectively.

THAT is the power of the lever!

* this is only a simple example - you could get more, you could get less income than this, depending on the property!