Understanding leverage: a beginner’s guide

Let’s call this person, Abby.

Abby has been a super saver and managed to save the full amount for her house. She hasn’t saved just enough for a deposit, she has saved the entire amount – so she doesn't need to get a mortgage (or use any leverage) – lucky Abby! P.S. How TF did you do that Abby?!

She decides to use her $700,000 to buy a house. Her ‘equity’ in her house is $700,000. She has used no debt.

Fast forward 12 months, and property prices in her area have gone up by 10% – yay! Abby’s house is now worth $770,000 ($700,000 x 1.10). She has made $70,000 ($770,000 – $700,000) in one year!

So, that $70,000 on the original amount she invested ($700,000) means she has made a return of 10% by investing in property.

If property prices had fallen by -10%, her house would be worth $630,000 ($700,000 x 0.9) and she would have lost $70,000 in the value of her house. She would have a negative -10% from investing in property.

Let’s call this person, Bianca. Bianca has also been saving her little bottom off and managed to save enough of a deposit to buy the house she wants. She has managed to use her KiwiSaver and savings to pull together $140,000 – amazing!

However, because the house she wants to buy is $700,000 (same price as Abby’s house), she needs to borrow the remaining amount of $560,000 from the bank. She uses $560,000 of leverage to purchase her first home.

Her ‘equity’ in the house is $140,000 (her deposit or her equity) and the ‘debt’ in the house is $560,000 (her mortgage).

Fast forward 12 months and, just like Abby, property prices in Bianca's area have also gone up by 10% – yay! Bianca's house is now worth $770,000 ($700,000 x 1.10).

However – now this is the key difference – because Bianca used leverage, she has actually made 50% return, not 10% like Abby. If you’re confused – don’t worry, I’m going to explain slowly (it took Soph a while to get this)!

The banks only ever want the $ that they lent you back, they don’t share in the house price movement. So, if the price of your house goes up, the bank doesn’t share in those gains.

With Bianca's example, since she put $140,000 into her house, and then once she pays back the bank the $560,000, she’s left with $140,000 (her deposit) + $70,000 (the gain in the house price) = 50% return!

In both examples, the houses went up the same amount, but the percentage return is much bigger for Bianca. Her return is 50%, compared to Abby’s 10%.

Why? Leverage. Moral of the story? Use leverage! It maximises your returns exponentially!

Leverage can be super helpful in boosting your returns when property prices go up, but also when property prices go down.

We now have Cindy. Cindy is in the same situation as Bianca; she has been saving her little bottom off and managed to save a deposit of $140,000 to buy the house she wants.

She buys a house the same price as Abby and Bianca’s at $700,000. Because she only has a $140,000 deposit she needs to borrow the rest ($560,000) from the bank as a mortgage. She uses $560,000 of leverage to purchase her first home – same as Bianca.

Her ‘equity’ in the house is $140,000 (her deposit) and the ‘debt’ in the house is $560,000 (her mortgage) – same as Bianca.

Fast forward 12 months and there has been a recession, and property prices in Cindy's area have actually FALLEN by -10%. Cindy’s house is now worth $630,000 ($700,000 x 0.9).

However, remember, Cindy used leverage. So her return is actually NEGATIVE 50%, not negative 10%.

The house is now worth $630,000. It has lost $70,000 in value from its initial purchase price of $700,000. Because the bank will want its money back (the $560,000 of debt), Cindy has to bear the entire $70,000 loss.

People tend to forget this part of leverage. It can be amazing on the way up, but a killer on the way down.

I hope we haven’t scared you with the leverage examples! But this is why we always say ‘you need to invest for the long-haul’ or a decent amount of time (5+ years) when investing in risky assets e.g property and stocks.

The graph at the beginning of this module shows that property prices do go up – but over a long period of time. Not overnight!

Another thing to remember is that yes, Cindy’s property value might have decreased by -10%, but that is only an ‘on paper’ return. It isn’t until she actually gets a real estate agent, lists her property and sells it to a new owner that she would incur that -50% return due to leverage. This is what we call ‘unrealised losses’.

Unrealised losses or gains are the movement down and up of an asset.

Realised gains and losses are when you actually sell that asset, and get that money in your hand or bank account.

I always hear people say ‘Omg, I’ve lost so much on my stocks’ or ‘Omg, I’ve made so much money on my property’. These are unrealized gains and losses, so don’t get too excited until they’re ‘realised’. They’re only on paper, and essentially meaningless unless you actually follow up with some kind of action.

Share prices and property prices move up and down all the time. Try your best to not concern yourself with these!

On a more positive note….leverage can be super helpful in other ways too.

In 2013, Loan-to-Value Ratios (LVRs) were introduced in NZ. These are limits for the banks to ensure they don’t give you a loan too high compared to the value of the property. In most situations and for most banks, the LVR is 80%. This means banks can lend you up to 80% of the value of the property. Technically there’s no LVR restriction for new builds. And for property investors (people with more than one home), the banks can only lend 65% of the value meaning they will need a 35% deposit.

If your house goes up in price, you can borrow more from the bank, as long as you’re within the 80% LVR limits. See diagram below.