Let’s start with a quick experiment, shall we? Warning! Everyone I have ever asked this question has gotten it wrong. (Unless they were a math teacher)
Let’s pretend that you had a line of credit (LOC) accessing the equity in your house. The interest rate on said LOC is 3%. You lend out $25,000 in a private mortgage at 8%. What is your return on investment (ROI)?
I bet at this point you are sweating a little bit since I told you, everyone, I have ever asked had gotten the answer wrong. But it seems so obvious! The answer has to be 5%. Right???
Mua haha! Wrong!
Sadly, this simple mistake has probably cost investors many a fantastic investment. If you think about it for a second, you might realize that you forgot about the effects of leverage. Let me break it down for you. There are a few calculations that need to be done.
First, the formula for ROI is:
ROI = (Net Return on Investment/Cost of Investment) x 100%
But we need to calculate the Net Return on Investment and Cost of Investment before we can get to ROI. So…
Net Return on Investment = Gross Return on Investment – LOC Interest Expense
Gross Return on Investment = $25,000 X 8% = $2000
LOC Interest Expense = $25,000 x 3% = $750
Therefore, Net Return on Investment = $2,000 – $750 = $1,250
And now we can calculate our ROI…
ROI = ($1,250 / $750) x100%
See, most people forget that the $25,000 was borrowed money; in other words, it’s not your money. You “rented” that money at the cost of $750 for one year. So, your “Cost of Investment” is the interest paid out of your pocket. Have you ever heard the term “Little hinges swing big doors?” It’s a metaphor for leverage. You spent $750 (little hinge) to use $25,000 (big door).
It would be different if you had taken the $25,000 from your savings, a.k.a. out of your pocket. Then there would be no leverage, and $25,000 would be your Cost of Investment.