Using a mortgage to buy an investment property is an incredible way to magnify your returns over time. Simply put, a mortgage is leverage. Leverage lets you use a small amount of something to move a large amount of something like in this picture.

In financial terms, the 10% down payment is the small amount of something that lets you control or “own” the whole house. You put down 10% on a $100,000 property. You have $10,000 equity and $90,000 debt. With a real estate investment, the annual income the property produces pays off the debt. You, the owner, receive the paid off equity.

Magnification of Equity Value Through the Use of Leverage

Below is one of my favorite charts. It’s from Kinneman’s Real Estate Finance and Investments. It shows quite simply how your equity (down payment, or the capital invested in the real estate) grows when the value of the house grows (price appreciation) based on the amount of debt (mortgage or leverage).

 The red line on the chart shows that for every 5% of property value appreciation, the equity value appreciates by 25% when using high debt. High debt is 80% LTV, which means a 20% down payment on a $100,000 house. Your loan is $80,000 or 80% of the value of the house, hence “loan-to-value.”

Equity Value Magnification for $100,000 House

Let’s look at the specific numbers associated with the equity and appreciation described above. I’ve used a $100,000 property value for easy round math. I’ve also added a line for “House Hack” to show how insanely high your leverage can be when putting 3.5% down using an FHA loan and the resulting insanely high equity gain.

Debt level is the inverse of down payment. 0% debt means 100% down payment. You bought the entire house cash and your equity is equal to the value of the house. Down payment, equity, and value all equal $100,000.

A typical debt level of 80% means you put down 20% or $20,000 and you have a mortgage of $80,000. In this case your equity is equal to the down payment of $20,000.

Now what happens to this equity when your property value goes up?

Your new equity is the result of the new house value minus the outstanding debt. For the sake of simplicity, this example assumes you haven’t paid down any debt.

My $100,000 house appreciates 5% and is now worth $105,000. My equity stays the same at $20,000. I still owe $80,000.

The math looks like

$105,000 asset - $80,000 debt = $25,000 equity

$25,000 new equity - $20,000 initial equity = $5,000 equity gain

$5,000 equity gain / $20,000 equity investment = 25% equity gain

This 25% equity gain is the definition of leverage. You had less equity in the deal, so every dollar gain in the asset price is a greater percentage growth of the initial investment.

Look at the same math with NO debt.

$105,000 asset - $0 debt = $105,000 equity

$105,000 new equity - $100,000 initial equity = $5,000 equity gain (same as above)

$5,000 equity gain / $100,000 equity investment = 5% equity gain

In the no debt example, your equity is the same as your purchase price: $100,000. The 5% price appreciation is equal to the equity gain. Look back at the initial chart and you’ll see the blue line for “no debt.” Every 1% increase in property value is also a 1% increase in equity value. Why? Because equity value is equal to property value.

Same Equity Gain, Much Higher Returns with Debt

Here’s a second chart to show the equity gains associated with the various levels of debt. Keep in mind the equity gain is constant at $5,000. The difference in percentage gain happens because that constant $5,000 is divided into the different equity numbers based on the amount of debt. Here’s the math for a $20,000 down payment:

$5,000 equity gain / $20,000 investment = 25% equity gain

Equity Ratio is defined as “equity gain” divided by “equity” or initial down payment. The lower the down payment, the higher the debt, the higher the equity gain %.

If we refer back to the first chart, this is what he means by magnification of equity value through the use of leverage.

What jumps out to me is that the typical American down payment of 20% on a house is deemed “high debt” by a sophisticated finance professional with years of teaching and investing experience. What’s crazier is that I am going to recommend you use a 96.5% debt level on your first house. This incredibly high debt load can be mitigated by taking the proper steps to combat the specific risks associated with a mortgage and the cost of debt.

See video accompaniment below: