Anytime you use borrowed money to make an investment, you are using leverage. In the case of buying a home, you probably have little choice other than to get a mortgage loan. Very few can afford to buy a home with all cash. However, even if you did have that much cash, you might still want to borrow money to cover part of the purchase.

For one thing, you might not want to tie up a large part of your cash in property. By borrowing, you can keep those funds available for emergencies or to take advantage of good investments as they appear. You are better able to spread your funds among many investments, so that you are not so dependent on the success of each one.

Finally, using leverage can improve the performance of your investment. You may not think of buying a home as an investment, but it is. First, you are investing in housing for the future. Instead of renting a home, you are renting the money to buy that home. It is true that you could lose that home if you don’t keep up the “rent” payments on the loan, but you don’t have to wony about losing your lease because the owner of the property changes plans.
Furthermore, your home can return a profit if it increases in value while you own it. Leverage will increase the rate of return you may realize on appreciation. For example, if you buy a home for $100,000 cash and sell it the next year for $110,000, your rate of return would be 10% on your investment. However, if you borrowed $80,000 to buy the home, the rate of return on your $20,000 down payment would be 50%.

Refinancing to take out equity keeps the maximum leverage working for you. In the example above, say you sold the home at the end of the second year for $120,000. With the original $80,000 loan, the return on your equity in the second year would be 33%. If you refinanced the loan after the first year for $90,000 (taking out $10,000 in cash), your return on equity in year two would be 50%.

The other side of leverage is that it increases your risk of loss. The more you borrow, the more pressure there is on your income to cover the payments on the loan. If you run into problems, you may have trouble making your payments. Also, if the property declines in value and you must sell, leverage acts to increase your loss. For example, if the $100,000 home is sold after a year for $90,000, you would suffer a loss of 10% of your investment. If you had used a loan of $80,000, however, you would have lost half of your equity.

In any financing or refinancing decision, you should keep in mind the effect the arrangement will have on your exposure to financial trouble.