Leverage is by far one of the most important concepts you want to understand for real estate investing. Even if you plan on paying all cash for your investments (congratulations), you should understand what leverage can mean for you and how powerful it can be. First of all, it allows for an easier barrier to entry into investing in real estate because you are essentially borrowing money from a variety of sources, mortgages, being the most common form. If you are willing to take the additional risk in growing your returns, leverage is your best friend but you must know how to best manage. Here are the 5 things that you must know about leveraging debt for real estate investing.

Comprehend the power

Understand that there is a lot of power behind using other people’s money and as much as they are willing to lend you, like a credit card. Doing this will allow you to have a lot more buying power than if you were to pay all in cash. This comes in handy when you identify multiple opportunities with great returns and like most of us, don’t have the means to pay all cash for those multiple opportunities. This is extremely powerful when it comes to scaling without having to pay it all in cash as you grow and it also helps you increase your returns at the same time. The majority of businesses at some point utilize leverage to help them grow and it’s more commonly used than you may think.

Understand the risk

Leverage does not just come without any potential downsides which can be detrimental. The more leveraged you are, the higher the risk but the higher the rewards, like higher returns. The key is to understand your risk tolerance and to understand when to draw the line. You do not want to find yourself in a situation where you are overleveraged and have little equity to sustain yourself in a bad economy or if you run out of liquid cash reserves. It’s a good idea to maintain a good balance of your debt/equity ration. Also, if you need access to cash, equity in real estate can be more complicated to liquidate but you can consider a home equity line of credit (HELOC)

Know when its the right time to utilize leverage

Before using leverage, consider doing the easy things first such as maxing out your Roth IRA or your employer match 401K. These accounts should be maxed out for the year before taking on debt for investing in real estate. Maximizing tax benefited accounts requires a lot less work on your part and the rewards are phenomenal. It’s not suggested to go leveraging debt to buy an investment property unless you have maxed out your Roth IRA or at least plan on doing so. Ideally, for this reason, real estate investing should not be your first vehicle of investing and normally it’s not in most cases because there is normally more money needed to begin.

Must have good credit

To get the best rates and essentially borrow money at the lowest cost possible, you’re going to need good credit. Borrowing money at its cheapest cost will maximize your returns. Of course, if your returns are good enough even if you don’t have the best interest rate then, by all means, go for it. At the end of the day, it’s all about the numbers or the return on investment(ROI). If the numbers make sense, so does the deal. Its always good practice to build up your credit score to take advantage of the lower rates and better loans because they eat up less of your returns. And because building your credit score is not too complicated, you must monitor and understand how it makes a difference so be sure to protect it carefully.

Must have cash reserves

Cash reserves are very important when you are leveraged in real estate. After all, you owe other people money and you need to make sure you can make at least the minimum payments to service that debt because believe me, they are going to want their money back with interest. Remember that your funding source also has an investment in the table by loaning you money and earning on the interest. You need to anticipate that sometimes your investments are not always going to be cash flowing, such as during vacancies. Having cash reserves acts as insurance in case you need liquid cash to deal with emergencies, such as repairs or any other personal or economic events.

Leveraging debt means using other people’s money to make (or hopefully make) more money. There are two sides to the coin in regards to leverage. On one hand, you will get the extremely conservative side who suggests you pay in all cash. But on the other hand, you get the people who suggest you leverage to scale faster and reaching for higher yield, which is not wise depending on how high you reach but it is very typical human behavior. At the same time, you need to be aware of the dangers before you utilize this magnificent tool. It’s very true when you hear that leverage is like a knife, in that, when used properly it can help you cut different things but sometimes it can cut and hurt you if you make a miscalculated mistake. Many wise real estate investors are conquerers of leverage.