How Much Real Estate Leverage Should You Use?

Not too long ago I heard an acquaintance say:

“When I bought my house I took the smallest down payment I could to increase my Real Estate Leverage for better returns.  Think of it, a 20% downpayment uses 1/5th the money of a cash purchase, so your ROI is multiplied by a factor of 5!  And a 3.5% downpayment is even better!”  

On the surface this sounds like it could be a reasonable statement.  Less capital invested in the deal, plus if you have the right incentives lined up tax-wise… could leave you with higher ROI.  Maybe.

Here I started thinking about the many reasons that are often cited for taking out a mortgage:

  • tax deductibility of interest payments
  • paying down the loan with “future” dollars which (thanks to inflation) are worth less.  (Worth less, not worthless.  At least hopefully…)

Was it true that if these benefits maxed out you’d get a higher ROI through leverage?

If that really was the case, it would seem that money is too “cheap” and that the cost of leveraging should be higher to align more with the inherent riskiness leverage brings.  My gut told me that this acquaintance’s statement was false.

I just had to prove it.  So to Excel I went.  (You know this means…pretty graphs below the fold!)

 

Comparing Cumulative Cost Basis

Your cost basis is just a fancy way of saying “the money you’ve put into the investment”.  And the cumulative part just means adding it all up since you started investing.  This is where the bulk of the differences between a cash purchase and a financed purchase happen to change your ROI.  We’re calculating ROI as:

(Sale Price – Realtor’s Fees – Amt Still Owed on Mortgage) / Cumulative Cost Basis

For A Cash Purchase, your cost basis is simply the price you purchased the property for.

For A Financed Purchase, there are upfront costs that include the down paymentloan origination costs, and points on your mortgage (pre-paid interest).  But then each year you continue to add to your cost basis since you are paying interest and principal payments, private mortgage insurance (aka PMI) if applicable, subtract the tax benefits that you are getting each year from deducting any mortgage interest, and as we add these costs to the cumulative cost basis, we use those discounted cash flow skillz to discount these future payments back to year 1 according to inflation. The yearly additions to your cost basis look like this:

(interest pmt + principal pmt + PMI payment – tax benefits)/ (1+ inflation rate)^(years -1)

  The equations are fun and all, but here’s the question we’re really trying to answer:

Will all of these tax deductions and lower cost “future dollars” overcome the amount that you are paying in interest and other fees?

I built a pretty awesome spreadsheet to test it all out.  If you want a copy, shoot over an email and I’ll send it over.

 

All Of The Spreadsheet Variables

As anyone who has ever bought a home can attest, there are what seems like a million different variables in the process and I’ve tried to account for as many as I could in this spreadsheet.  Things you can adjust are:

Purchase Price – Median US home price was $173,200 in Jan 2013, so I’ve used that for all these examples

Percent Down Payment – The examples here are for the minimum conventional loan (20% down) and the FHA minimum of 3.5% down.

Mortgage Terms – Interest Rate, Points Required, # Years.  We’ll fiddle with these assumptions a bit in the examples below.

PMI Rates – Rules for PMI recently changed.  FHA increased the PMI yearly premium to 1.30% of the loan value and required that PMI be paid for the entire duration of the loan.  That’s right.  PMI payments no longer disappear once you hit the magic 20% equity unless you refinance into another loan.

Loan Origination Costs – The US nationwide average for mortgage origination costs on a $200K loan are $1,600

Marginal Tax Rate – What tax bracket are your mortgage interest deductions saving you money in?  I use 25% for all the following examples (mostly ’cause that’s our marginal tax bracket).  In all of these examples, I am VERY generous and assume you get the full benefit of your tax deduction from mortgage interest despite the fact that many people cannot itemize tax deductions .  (The PoPs included.)  If you get the spreadsheet you can toggle this on/off.

Inflation – I took the average CPI from the past 20 years.  It was 2.50%.  That was used as the inflation rate in all of these calculations.

RE Growth Rate – Long term, on a nationwide basis, RE growth tracks inflation.  But I left it as a variable we can toggle to test what happens if you’re in an area like SF or NYC that has had long term growth rates above inflation.

Realtor’s Fees Upon Sale – I assumed 6% since that’s a pretty fair industry standard for the seller to pay. Whew, that’s a lot!  So let’s look at an “average” example.

 

An Average Case – 20% Down

Here we’ll use all the “average values” for our mortgage and real estate atmosphere.

  • Mortgage Terms: 20% Down Payment, 6.45% APR with 0.97% points (these are the 20-year average of 30 year conventional mortgage rates and the points required to get those rates), 30 year loan
  • Inflation = RE Growth Rate = 2.5% assumes that the housing market tracks inflation.

Here’s what our results look like.  The blue line is the ROI on a cash purchase, the red is the ROI on your mortgage financed at those “average” terms. The graph says it all, right?  At no point in the 30 year loan period can you expect that leverage to pay off with an investment boost. A cash investment would have had a 97.2% ROI, which is almost double the 49.9% ROI on your mortgage financed purchase.

What About Increasing the Leverage Even More?  Does That Help?

 

An Average Case With More Leverage – 3.5% Down

Same terms as above, but with 3.5% down instead of 20%.  In this case, you have PMI which is 1.30% per year, but since we’re only dealing with an average interest rate, we generously assume that you can get a no cost refinance into another loan with an average interest rate the year that you hit 20% equity. So what happens? It’s even worse, especially in the early years. Notice it takes until year 21 for your financed purchase to have a positive ROI after calculating your adjusted cost basis. Kindof scary, right?  After 30 years, you’ll have a financed ROI of 37% instead of 97% for a cash purchase.

But Interest Rates Crazy Low Right Now.  Nobody’s Paying 6.45% on a Mortgage Right Now!

True, so let’s try some more current mortgage rates.

 

2012 Interest Rates – 20% Down

Same variables as used above, but the mortgage terms reflect the conventional loan averages from 2012, which are historic lows.  (Though they are headed back up as of late…)

Mortgage Terms: 20% Down, 30 year loan @ 3.66% APR with 0.70% points

With 2012 interest rates, the gap starts to shrink, and by year 30 we’re within 10% of the 97% gain from cash.

But you’re still in negative ROI territory for the first 8 years.  Put another way, it takes 8 years not to lose money on your housing “investment”.  A smaller downpayment (3.5% – graph not pictured) is even worse, shaving another ~10% off your 30 year return to put it at 76%.

 

This Isn’t Fair.  My Housing Market Is Special, And It Will Grow Faster Than Inflation.

Most housing markets aren’t special and don’t grow faster than inflation.  But there are some areas where continued population growth and investment in a fixed geographic area has led to housing prices rising faster than inflation on a consistent basis.  So what if our highly leveraged acquaintance bought in one of these areas?

 

San Francisco With 2012 Mortgage Rates – 3.5% Down

San Francisco is perhaps the most extreme example, with one of the longest periods of sustained RE market growth in the US.  It has had a compound average growth rate of 4.4% from 1986 – 2012 (well over the 2.9% compound CPI for the same period).

So what happens when we look at that 3.5% down payment mortgage in a booming market like San Francisco’s?

Even with that generous growth beyond inflation, that 3.5% down payment still doesn’t come out ahead.  It’s a close match in the middle years (say 13-16), but a cash purchase still comes out ahead in every single year.  (By contrast, a 20% down payment in a SF style market would actually show financing working in your favor during the middle years, 10-20, of your 30 year investment horizon – eking out small gains over a cash purchase.)

 

Take Home Message

Interest is a cost.  A quite significant cost most of the time.

Does this mean everyone needs to save up and buy a home in cash?  No.  We’d be hypocrites to say that.  There are many other reasons besides ROI to choose a specific downpayment.  But be wary about anyone who’s encouraging you to have a smaller (percentage) downpayment.  Chances are they’re either mis-informed or don’t have your best financial interests at heart.

What size downpayment did (or will) you use when buying a home?  What are some of the reasons that you had for choosing that down payment at the time?

53 comments to How Much Real Estate Leverage Should You Use?

  • Agreed. Interest on your mortgage is a cost. My interest not paying a mortgage is making me money in the bank.

    We do have to take on debt to get in to a house but we don’t have to live with it for 30 years and refinance and roll our credit card debt in to it. $15,900 left until I am debt free then my money will be working for me instead of for the shareholders of the bank.
    Jane Savers @ Solving The Money Puzzle recently posted..Who Really Controls The World’s Money And What Happened To My Invitation To Bilderberg 2013My Profile

  • AWESOME POST!!! I don’t think I could use enough CAPS or exclamation points. It always irritates the crap out of me when people talk about interest rates dictating the affordability of houses. NO!!! It’s the price!!!! And people way overestimate the benefit of deductible interest. First, you still end up paying the great majority of it. And second, like you said, not everyone gets it. And even if you do, it’s really only the amount above the standard deduction that should count as an actual benefit.

    The one thing that could be added here is any investment return on your money if you choose debt instead of paying in full. That would be I think where most of any extra return would come from.
    Matt Becker recently posted..How to Check Your Social Security BenefitsMy Profile

    • You’re 100% right that I left out any investment return if you invested the difference. Maybe I should spell that out in the post above – the post was just getting so long… But the big reason that I did that was because this particular acquaintance could have adjusted their spending over the course of a year and saved the difference between a 3.5% down payment and a 20% one. Easily. Instead, he told himself he was getting a higher ROI with the 3.5%, didn’t change his 401K witholdings, and invested no additional money.
      While there are some people who do use the opportunity to maximize leverage and invest for higher returns elsewhere, I think most people are like my acquaintance here that don’t.

  • There is one thing that I think is missing though. It seems that the post assumes you don’t do anything with the money that you didn’t put down on the home.

    We are going through a similar situation now. We could have paid cash for our $200,000 house, but decided not to because we got an interest rate of about 3%. We are putting 20% down and will invest the rest. In P2P lending, I earn 10%, so it seems like a no brainer not to tie this money up in a mortgage.

    The other variable for us is that we’ll probably turn the place into a rental. From studying the market, we could get at least $1500/month in rent while our mortgage, taxes and insurance will come in at less than $1100. If we had paid cash, all of our reserves would have been gone and we would have had to wait an additional year to purchase another.
    Mr. 1500 recently posted..Ask the Readers: What Moves You?My Profile

    • “The post assumes that you don’t do anything with the money that you didn’t put down on the home”.

      Nail on head, though perhaps I should point out in the post that this was intentional for the reasons that I described in my reply to Matt above. Having an investment plan for the funds you don’t put into the house changes the equation for sure. I think most people don’t have a plan like yours and instead end up squandering the money.

      I may have missed the mark and need to tweak this post a bit. The goal when I set out was to compare the 20% down with the 3.5% scenarios, and I think I might have lost that in starting from my friend’s comments and comparing with a cash purchase.

  • Patrick

    I have to disagree with you guys on this one.

    First, anytime you choose to finance when you have the means to pay cash, there needs to be some mention of opportunity costs. If you have the option to buy with cash but instead finance, you should take that money you didn’t spend by financing and invest it elsewhere. When you do that, your overall ROI is greater when leveraged because your outside investments should outpace your mortgage interest rate.

    Second, if you apply this to an income-earning investment, such as a successful rental, your ROI will always be greater when leveraged.

    • I’ll repeat what I said above.

      I may have missed the mark and need to tweak this post a bit. The goal when I set out was to compare the 20% down with the 3.5% scenarios, and I think I might have lost that in starting from my friend’s comments and comparing with a cash purchase.

      Having an investment thesis for the difference in used funds changes things, but the thing is, I think most people don’t have one. And instead they’ll just keep their other investments on auto-pilot like my acquaintance and absorb what they could have saved into additional spending. Like on fancy entertainment systems and furniture for said new house.

  • Jonathan

    Normally I find PoP real estate analysis to very inciteful. This one, however, leaves a lot to be desired. First of all, this metric “ROI” as defined is essentially meaningless. You’re calculating your home’s initial purchase price as a percentage of what you directly paid for it over time. A return is the expected financial benefit of an investment – money that comes back to you as a percentage of what you paid, and hopefully it’s positive. In your house-buying scenarios, all of your actual returns, calculated in a normal way, are negative.

    Yes, you are correct that all else being equal on a house you own for 30 years, if you pay all cash vs. financing it, assuming both are equally feasible on the same day, your total out of pocket cost will be less on the cash purchase. This is very simple arithmetic. However, not all else is equal. If you’ve got enough cash to pay cash, then you can almost certainly find a good investment that will pay more than your interest costs of financing. In most cases, for a financially prudent individual, it’s far more cost-effective to take the financing. And for most people, who would have to save for many years to get the full purchase price, the cost of renting a home in the meantime has to be factored in as it’s a real cost of the “save up to pay 100%” plan.

    Most importantly, real estate leverage is usually discussed in terms of actual real estate investments – those purchased with the intent to make a profit. This article did nothing to answer that question.

    I suspect that your spreadsheet could be very useful if you tweak the output formulas to calculate something meaningful. I would love to take a look.

    • Jonathan

      Excuse me, inSIGHTful. How embarassing :)

      • haha, I assumed that it was just a typo and you weren’t accusing me of trying to incite a riot! =) But if you don’t mind, I will send you that spreadsheet to the email you used for this comment. Would LOVE to see your input.

    • PK

      I don’t know if I’d go so far as to say it’s worthless, but I agree with Jonathan that it does neglect opportunity cost. I think there is value in showing people the relationship isn’t automatic – and of course you obviously can’t factor in all the types of behavior (multiple Refi? HELOC? HEL?) that come with a rising price.

      As to Jonathan’s point – if you have $1,000,000 for a million dollar house, you could employ $800,000 in a different investment. Hence the real estate calculations of Value at Risk and Cash on Cash return.

      Side note (joke!) – hope my silly leverage calculations the other day don’t cause you to do anything rash, haha!
      PK recently posted..How Did Your Stock Investments Go Last Year?My Profile

      • PK, your comments the other day have 0 to do with this post. It was in the queue for a while and I didn’t even think about it. =)

        I think maybe I need to go back and rewrite this a bit and I really appreciate all your input. Like I said, this was originally intended to compare a 20% mortgage with a 3.5% mortgage, but I think I ended up off the mark when I started from my friend’s remark about cash purchases.

        The thing is, for most people choosing between saving up for a larger downpayment or buying when they hit 3.5%, they’ll never save up and invest the difference even if they should have been able to by adjusting spending patterns.

        My acquaintance didn’t change his investing habits a bit. His 10% 401K investments (including employer match) were the same before and after his purchase, with no intent to change that. And I think most people are just like that, especially once they’ve convinced themselves that their house is a great investment rather than a place to live.

    • Jonathan, I always appreciate your comments, especially on the RE posts, so I’ll definitely shoot you a copy of the spreadsheet tonight when I’m back at a my home computer. I’d love to see your take on it.

      “Real estate leverage is usually discussed in terms of … those purchased with the intent to make a profit.”
      I think that’s part of it. My acquaintance had himself convinced he was buying an investment when he was really buying himself a place to live. Those are two very different concepts, but popular culture seems to be conflating them more and more and confusing homebuyers by convincing them they are real estate investors.

  • Trying to play the game of leveraging real estate can bite you in the butt when real estate prices fall or don’t appreciate as quickly as you anticipate. Personally, I think it’s extremely speculative.
    Tina @My Shiny Pennies recently posted..Why I Wrote a Will Even Though I’m not a MillionaireMy Profile

    • Risky, indeed. There are more than a few former homeowners who played the game and lost a few years back when relying on unsustainable growth rates that didn’t come to fruition.

  • Those are some intriguing findings. I haven’t seen the spreadsheet to see if it accounts for any opportunity costs – that may be something to consider. That said, my wife will be very happy to read this post to justify a cash purchase. So, thanks in advance!
    Done by Forty recently posted..Thirty Things LighterMy Profile

    • Haha, happy to help out the wife. The spreadsheet doesn’t account for opportunity costs for the reasons I outlined above. I think most people who are choosing between a 3.5% and a 20% mortgage are likely to ignore investing the remaining money and just inflate their lifestyles rather than spending more. I think I confused the issue by tossing the cash purchase in there, but the above numbers are (I believe) all correct.

  • Anne

    I agree someone who could have paid cash or put a larger down payment on a home could have used the funds they didn’t put down on investments, but I also agree with Mrs. POP that most people don’t do that- they put the minimum 3.5% down instead of 10% or 20% to be able to furnish it faster, or whatever.

    I’m not convinced the post needs rewritten, but I’d be very interested in a follow up post comparing someone who blows that 16.5% they didn’t put down to avoid PMI, and someone who invested it.

  • This is a great post and very detailed. It’s great to see that the power of cash outweighs the power of financing. The one thing that is neglected (and a few people mentioned it above) is that if you financed instead of putting 20% down, you can invest the difference at somewhere around 8% return. This would probably sway the argument a bit more in the way of financing, but you are also taking on a lot more risk doing it this way, too.
    Jake @ Common Cents Wealth recently posted..The Rule of 72 and Impact of Compound InterestMy Profile

    • More risk, and I think most people would neglect to invest the difference. They’d inflate their lifestyles and just spend it rather than change their current investment allocations. Heck, that’s what my acquaintance did. =)

  • I put 25% down on my UK mortgage to get a better deal. Otherwise since the property had a pretty positive cash flow I would have put less and kept the cash reserves, since the rate is 2.29%
    Pauline recently posted..I need your help! Please help me pick a logo!My Profile

  • I needed to read this post a few times to make sure I really understood it. The graphs are beautiful! Before you ran the numbers, I would have guessed that being highly leveraged in SF would absolutely win, but I guess that’s why you run the numbers.
    It sounds like this would be a useful analysis for someone looking to either settle for a normally priced home they can afford with a 20% down payment,or stretch for something pricier with just a 3.5% down payment. What if I had the money for a 20% down payment, but wanted to evaluate that against buying the same priced home with a 3.5% down payment and investing the 16.5% in the stock market or something? What do you think your model would spit out then?
    CashRebel recently posted..Irrational Consumers and Electric VehiclesMy Profile

  • “It sounds like this would be a useful analysis for someone looking to either settle for a normally priced home they can afford with a 20% down payment,or stretch for something pricier with just a 3.5% down payment.”

    That’s absolutely who I had in mind when writing this!

    “What if I had the money for a 20% down payment, but wanted to evaluate that against buying the same priced home with a 3.5% down payment and investing the 16.5% in the stock market or something?”

    Back of the envelope calcs, you figure that you’d need to earn enough on the 16.5% ($28.5K of $173K) to pay the additional mortgage interest (at 2012 interest rates, this would be an extra $1050/year), and then enough on top of that to pay your 1.3% PMI premiums, but the PMI premiums apply to the initial principal (in this case, 96.5% of $173K), not just the difference between the two down payments (so that’s an additional ~$2170). So in year 1, you’re looking at an extra $3220 in costs that you’d need to try and find a way to make up with your $28.5K that you have to invest. That’s about 11.2% that you’d need to hit… though these don’t include any tax benefits you might be eligible for…

    As you can see there’s a lot of moving parts, so it’s not super straightforward. But I think what most people look at is that they think they’re golden if they beat the interest rate (3.66%), when in reality the PMI costs if you’re going with a 3.5% mortgage can add up big time since they apply to the whole loan amount instead of just the difference between the down payments.

    I think I’ll take Anne’s suggestion and try to pull some more case studies together to see what returns you’d need on investing that 16.5% to get a similar yield on a 3.5% and a 20%.

  • Personally, I think everyone should have 20% down to buy a house. Some people might have the cash sitting around and invest it otherwise, but most people buy as much as they can with as little as possible. Thus the real estate crisis and why so many people got foreclosed upon.
    Kim@Eyesonthedollar recently posted..Botox, Fake Tans, and Tatooed Eyelids: The Price of Beauty Is Too HighMy Profile

  • spiffi

    I put 47% down on my mortgage, because I had calculated that I wasn’t willing to borrow more than 200k, based on the required monthly payment, property taxes and HOA fees. Since home prices in my area (Silicon Valley, CA) meant that a 3 bedroom condo was over 350k, I had to make up the difference in the down payment, or not buy.

    I can’t count the number of conversations I had with others who tried to convince me that the “mortgage interest deduction” meant that I could *easily* afford a much bigger loan, and that all those TAX SAVINGS would make it worthwhile!

    • Nice, that’s awesome that you had a firm cap on your borrowing limits. I’m willing to bet that your mortgage lenders were saying you were pre-approved for way more than that, too!

  • The big question for me is what else could you be doing with the cash. Money not put into the downpayment could be invested elsewhere and providing returns greater than the interest that would be paid on it.
    My Financial Independence Journey recently posted..Exxon Mobil (XOM) Dividend Stock AnalysisMy Profile

  • We put zero percent down on our first home (ZERO!!) We were young and dumb at the time. I would never do that again. Interest is a cost but PMI is a total waste.
    Holly@ClubThrifty recently posted..An Anchor, a Stripper and a Goat-Hair Collector: The World From Different Points of ViewMy Profile

  • Am I really here! It feels good to be back at the House of PoP again after my long launch hiatus. I see you haven’t lost your touch with the spreadsheets. This is like showing a little leg to a numbers nerd. I get all hot and bothered. 😉

    So, rather than parrot what others have said about opportunity cost, I’ll say this: the true conflict here is that the acquaintance is starting without the end in mind. Rather than beginning with a goal and deciding how much they should put down on a house instead of keeping in their investments, they’re starting with a false assumption around “how I maximize my money.” It’s a sad place to begin.

    I’ll bet you use spreadsheets in all of your decorating, don’t you?
    AverageJoe recently posted..How To Become a Great Saver (It’s Not As Hard As You Think)My Profile

    • haha, welcome back, Joe! Happy to provide the spreadsheets so you can get your weekly fix.

      As for decorating with spreadsheets, I have been known to toss a tracking sheet up on the wall to track runs or project progress from time to time. Nerdy, I know!

  • Ha, great timing on this post! I just bought an investment house like 30 minutes ago.

    Down payment: 100%

    Risk factor: very low

    I’ll be getting an ROI as soon as the first rent check clears. It’s the least risky way to buy real estate no matter what the tax adviser or all the fancy numbers say. I want as little risk as possible.

    Great post!
    Jason Cabler (@DrCabler) recently posted..Money Making Idea #4- Freelancing Using Your Existing SkillsMy Profile

  • This is really interesting. Our financial planner’s idea last fall was for us to sell our condo and finance the purchase of a house with a FHA loan with just 3.5% down. I didn’t like the idea because it involved selling our condo (and taking a huge loss) and paying a ton of fees for the FHA loan. I didn’t realize the fees for FHA loans were even greater now.
    Mr. Bonner recently posted..The financial stages of lifeMy Profile

    • The FHA stuff increased a couple of months ago – and the rules on PMI are in flux, too. For now, it looks like they’re tax deductible, but that’s a temporary exemption that Congress has to extend every year, so like the temporary payroll tax cut, I wouldn’t count on it being there indefinitely.

  • Lucas

    Not sure if this was mentioned in the comments anywhere, but you also need to account for cash flow (rent on the property). I am against heaavy leaverage becuase of the risk, but bear with me here. If you can buy a property at 10% down that is cash positive meaning your rent more than pays for interest/mainentnace/tax costs then you effectivly multiply your cash flow and asset appreciation by leveraging. I would never leverage to buy something that wasn’t possitive cash flow, but if you can then you have a good investment that will beat a full out purchase for ROI (when you include the rest of the money you put away).

    I think you need to start with a set amount of money as an example. So if you have 100k. and can use it to buy one property outright, 4 at 25%, or 10 at 10%, what would that look like given different RE returns, rents, interest levels etc. . .

    • If you’re buying a rental property, then yes I agree. Like I mentioned to some of the other commenters, this was really meant as a post about a person buying a home to live in and deciding between a 3.5% and a 20% mortgage. I missed the mark and should have been more explicit about that for the assumptions.

  • I actually enjoyed the post and I actually appreciate an analysis without the convolution of opportunity cost (in this instance). I agree it is essential in the full discussion but I like the argument being made in the context of down-payment percentages. What is touched on but not completely discussed (again, due to the scope of the article) is the risk factor when making purchases. This is often left out by the leverage and invest crowd.

    I too feel like the ‘mortgage interest deduction’ is overrated and more of a sales tactic than an actual sticking point for the vast majority of home buyers. Very interesting post and I enjoyed the graphs and spreadsheets.
    Stephen at SE recently posted..The Free Digital Envelope SystemMy Profile

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