A recent leveraged-investment discussion revealed that people can calculate a high Return on Investment (ROI) from borrowing by not counting the debt principal as a cost and (in one case) not counting the debt interest as a cost.
Consider a choice to invest $250 cash v. $250 debt:
Investing cash to earn 10% earns 10%.
Investing debt at 5% interest-cost to earn 10% earns net 5%.
However, it is common to claim that debt gives the higher ROI.
Free money, for the asking, no strings attached, no debits
Financial analysts can claim that debt gives the higher ROI by not counting the debt principal as part of the investment, yet counting the net returns from debt (your ROI sprouts from "nothing"). The argument is that the debt is "not your money," although a credit check of your name would not agree completely and at the very least the argument ignores the legal liability, risk, insurance requirements, effect on credit score, credit score's effect on other loan rates, etc.
Infinite ROI, infinite profits
Excluding the debt principal from the initial value of an investment certainly can raise the apparent ROI. However, that argument suggests that 0% downpayment gives you infinite ROI when we all know that, for any given dollar amount of investment, you would be poorer by borrowing more of it and richer by borrowing less of it (as in the "Consider a choice" above, and the example below).
Wait, there is no such thing as a free lunch after all
While a high ROI seems efficient, at some point you want to maximize your profits in dollars rather than percentage points. You cannot buy lunch with percentage points. You need dollars.
Look at your real estate profits here in Net Operating Income (NOI):
$250,000 [100%] paid in full in cash:
--$26,400 in rents - $3300 expense = $23,100 NOI
--$23,100 / $250,000 = 9.2% ROI
$25,000 [10%] cash down payment [plus $225,000 mortgage]:
--$18,879 in mortgage payments + $3300 expense = $22,179
--$26,400 in rents - $22,179 = $4221 NOI
--$4221 / $25,000 cash in front = 16.9% ROI
example from: Using Financing for Real Estate Leverage
The NOI trend gives you an idea of your hard-earned money that you keep by putting a larger downpayment on your mortgage (although this is a rental example).
These types of examples are very common to extol leveraging but you can see the trend that the more you pump up the ROI, the less money you make.
Cocktail-party bragging rights to the higher but leveraged ROI will cost you $18,879.
How high an ROI do you want?
(PS: The NOI informs you that the leveraged ROI is inflated because it ignores that you left $225k cash idle and (apples to apples) the actual leveraged ROI here is only 1.7% ($4221/$250k), or 0.9% ($4221/$475k) if you include the $225k mortgage to discount for debt risk.--Note added 7/25/07, last updated 7/30/07)
Leveraging multiplies scale, volume, and risk but I will leave that for a future article. Alternate uses for the same money (opportunity costs) such as stocks or arbitrage are separate choices and each can be leveraged or not leveraged.
Next: Inflating Leveraged ROI Can Ruin You
Never Prepay Mortgage? Housing Myths Part 1
The $200,000 Blunder: Housing Myths Part 2
Home Mortgages Are Bad Investment Tools? Housing Myths Part 3
Homeowner Profits Ignore Huge Costs: Housing Myths Part 4