Should I buy my house in cash, or with a mortgage and invest the rest of my money?
I can afford to buy a house (to live in myself) in cash. Most of my investor friends tell me this would be a dumb idea, because I could earn more in interest by buying the house with a mortgage and investing the rest of my money.
I get their arguments, but they appear based on less-than-certain assumptions:
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I’d be able to get a reliable return on my investment higher than what I pay in interest for the mortgage.
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I’d keep the mortgage long enough for my investment returns to exceed the cost of interest.
1 is probably a safe assumption, although by no means a given. Currently, no guaranteed-return investment instruments (e.g., CDs) would come close to paying an interest rate that equals or exceeds the ~3.5% interest I’d pay on a mortgage. The stock market does beat that, of course, but it could tank.
2 is where I think a lot of people fail to understand the financial benefits of buying a house in cash. Because of amortization, the amount I would pay in interest each year for my mortgage would be very high at the start of the mortgage, and would decline gradually. Effectively, the cost of the mortgage in the first year would be much higher than the nominal ~3.5 percent interest rate of the loan.
As a result, I’d have to keep the mortgage for more than a decade before my yearly investment returns started to exceed what I pay in interest each year on the mortgage. Given that most mortgages last only 5-7 years before people refinance or move, it seems uncertain that I’d end up with more money in the long run by taking out a mortgage.
At the end of the day, buying the house in cash seems smarter to me, which is effectively the same as getting a guaranteed return equal to what I’d otherwise pay in interest for the mortgage — which, again, would be many thousands of dollars in the first year I own the house.
(Also, another reason not to get a mortgage is the new US tax law’s implication that I, along with 94% of the rest of the country, will not itemize my deductions because I won’t hit the standard deduction. There are, effectively, no tax advantages for mortgages anymore for most people.)
For the record, my main reason for buying the house in cash is emotional, not financial. I’ll sleep better knowing that if I were to lose my job, I won’t have to worry much about leaving the house, because my only major monthly expenses are property taxes (which are pretty hefty here in New York, but still less each month for this five-bedroom house than it would cost to rent a one-bedroom apartment in the same town).
Still, I’m looking for an answer for my friends who are overlooking the complexities of mortgage amortization and how that impacts the real cost of a loan within the first decade or so. Am I wrong?
It may depend upon your location.
In Virginia, per § 58.1-803 :
In other words, a 0.25% additional tax is imposed on the borrowed amount by the state, that you would not have owed if you paid all cash.
Furthermore, localities (counties, cities) then impose an additional tax, for example 1/3 of the state tax. So you are up to 0.33% tax.
Other reasons to pay cash are to avoid closing costs, especially appraisal. Title insurance and homeowners insurance become optional if you pay cash.
Also, you can make a stronger offer to the seller with less contingencies if you can pay cash.
I’ll take this literally. Case closed.
One can offer all kinds of math, analysis of the market over time, etc. Or my own experience, Retired, With Mortgage, in which I documented how my decision, to go with the mortgage, was right for me. (Note, mine wasn’t exactly mortgage/no mortgage, but a look at my retirement account return vs mortgage cost). The fact that the market return was quite higher than the mortgage in the 15 year period I discussed was interesting for the fact that the timeframe contained 2 major crashes including the dotcom bubble and great recession.
That’s what your “friends” are likely to tell you. The math.
If that sentence I quoted is true, the potential extra money isn’t worth it. The only concern I’d share with buying a house with cash is that you have a proper emergency fund set up. A budget with no mortgage payment is great, but as you note, you’ll still have property tax and insurance to pay.
Last, the mortgage for some acts as forced savings. Look at it this way – you have $XXX, a sum which I’d label as “retirement savings” if I saw it on one’s balance sheet. A big chunk of that gets spent. I’d suggest you take the non-mortgage payment, not due each month, and funnel that extra money to the retirement account, don’t let it just slip into the budget as extra spending.
There are plenty of good answers here already but there’s something that should probably be noted: an increase in value of your house is less certain than an increase in the value of your investments.
While most of the argument for buying via a mortgage vs. buying in cash boils down to overall investment returns being higher than mortgage interest rates, there’s also the additional benefit of diversifying your assets.
Lets look at one of your points:
While it’s true that you would save on interest payments, the value of your house could also decrease. And while it’s entirely possible, if not likely, the value of the market as a whole could also decrease, you are exposed to much greater risk by having all of your money in a single asset vs. diversifying it.
There are also non-market risks that could cause a house to lose value, many of which are not typically covered by homeowners insurance. Examples include:
While these may not be an end-all for your home value, they could significantly decrease how much the property is worth, and/or could make selling the house later on significantly harder. While something like termite damage, flooding or mold would still likely cost you money in repairs with a mortgage, if you spend most of your cash on a house, you could end up with much less cash after paying for repairs.
While you may still lose more net worth if your house decreases in value under a mortgage (as you still need to pay the same amount of interest), you would still have a larger cash value than you would if you had spent all your cash on the house.
Additionally, having most of your value in a house as opposed to cash or other assets makes it significantly harder to even realize your losses: if your house loses a large chunk of its value, you still need to sell it in order to get cash in hand. And selling a house is a lot harder than selling other forms of securities such as stocks, bonds or funds.
The Takeaway: When you buy a house in cash, you are effectively putting all your money into a single asset. A smart investor would not recommend put all their money in a single stock or even a single market. Putting a large chunk of your value into a single asset is not a very good idea, even when it serves a purpose as a residence.
At the end of the day, buying the house in cash seems smarter to me, which is effectively the same as getting a guaranteed return equal to what I’d otherwise pay in interest for the mortgage.
For the record, my main reason for buying the house in cash is emotional, not financial. I’ll sleep better knowing that if I were to lose my job, I won’t have to worry much about leaving the house, because my only major monthly expenses are property taxes
These are two great reasons for buying a house outright if you can. Both of them are about reducing risk. It makes sense for a hedge fund to take on risk in order to increase returns. For most people who are not wildly wealthy, it makes sense to do the opposite. Risk has multiple costs – the cost of stress and worrying, the cost of the energy you will have to spend resolving problems like being broke, the cost of being forced to move or take on a less than ideal job. That’s why insurance exists.
As you point out, setting off interest payments against tax could have been a good counter-argument, but it no longer applies.
I know this is an unpopular idea so let me preface this with I’m not a professional and this is just my opinion.
I’ve considered this option as well a few times. Does it make sense to pay off loans entirely or to continue to pay on them and invest those funds elsewhere. I have to break this answer up because theres a couple things I keep in mind.
I have multiple investments like many here and the thing that I love most in them is reduced risk. I always look to reduce risk if things go south.
So, in regards to your question. If the housing market were to tank again, I’d rather have a few thousand of my capital tied up in a loan on a house as opposed to 200k or 300k of my capital tied up in a house that’s worth half. Let the bank take the risk.
My second point is what are you ACTUALLY saving each month. Let’s say I have a mortgage of 1300 a month. Obviously that mortgage isn’t just principle and interest. It’s made up also of escrow for taxes and insurance as well.
I don’t know about most people but my taxes and insurance make up the bulk of that monthly payment. Guess what, you pay that loan off and you STILL have a large monthly payment for taxes and insurance. So you tie up hundreds of thousands of your liquid capital into equity on a house that you still have to pay monthly for? Seems like putting all your eggs in one basket.
Now the only caveat here is I WOULD recommend making at least 1 extra mortgage payment per year. Making just one extra payment a year would reduce your 30 year loan down to something like 17 years, vastly reducing the amount of interest you pay. The biggest fallacy I see people make is they buy a 100k house, pay on it for 30 years, end up paying 2.5 times as much for it and then sell it for 200k thinking they made a huge gain.
Just make sure you don’t put all your cash in the house. Mortgages with large down payment are typically very cheap, much cheaper than a typical car loan for example. So it might be wise to get the mortgage and have the money to buy a new car/boat/whatever two years down the road, instead of having to borrow or wait until you save enough.
Of course, if you have enough cash for the house and for foreseeable future purchases, you don’t need the mortgage.
There are answers of varying quality here and some of this will likely repeat some of that. There are a lot of things to consider here and I think it will help to organize the key factors.
First of all, your assertion that the interest is higher at first is completely incorrect as mentioned in other answers. Your rate is what you pay on the remaining portion of the loan. So your first payment will pay a month’s worth of ~3.5 interest on (more or less) the entire initial balance of the loan. The next will pay interest on a slightly smaller amount and so on and so forth. In the later part of the loan each payment goes almost entirely to principal. You are over complicating this. There are other costs that you pay with a mortgage that you will not recoup. That’s what determines how much you need to earn on the investments to break even.
You need to think about how much cash will you have left after the purchase. When you own a home you need be able to maintain it. You’ll need a new furnace at some point. A new roof. A new water heater. Appliances. You need to furnish it. If you buy a fixer-upper and improve it, you can save a lot of money. But in order to fix it up, you will need cash.
The money you put into a home cannot be accessed unless you either sell the (entire) home or take out a loan. You can sell 10% of your shares. You can’t sell 10% of your home.
If you purchase the home outright, you assume the entire risk of its value dropping. If you have a mortgage you have an option to walk away. Yes, it will totally wreck your credit for 7 years but people have done it. During the housing bubble people took loans against their equity and bought a boat. Then they walked away from the home with the boat. Not saying I would do this or that you should but you can treat the mortgage as a hedge against tail risk such as a biblical flood.
One advantage of paying cash is that you may be able to get a better deal. Having sold a home and my dealing with my buyer’s contingency and the buyer’s buyer’s contingency stressed me because my new home purchase was contingent on their contingencies, it became clear what an advantage it is to come in with an offer in cash. You may be able to get away with low bid on the home.
If buying a house will basically leave you with no rainy day fund, you should surely NOT do it. Consider 15 or 10 year mortgage and/or a bigger downpayment. You’ll get a better rate and keep more cash on hand.
One alternative possibility: Take out a mortgage on the property you want to live in and buy another property with your cash and rent it out. You should be able to get enough rent (after costs) to cover the cost of the mortgage. Once the mortgage is paid you’ll then have two properties.
Of course, you do need to buy a rentable property and keep it occupied and maintained but all good investments require work.
Paying cash is better because usually it’s a fixer-upper that you can get for a good price or through Sheriff sale or through a local community public housing sale we’re basically cash is King.. through my own experience you buy with cash, get a good price, and then you live in the home that you just bought and you fix it up while living in it and either have a small loan that you’re paying off but you’re living in the home that you’re fixing for profit so it’s a win-win that’s my opinion..
One actually needs to earn a rate of return on investment greater than the mortgage rate plus the taxes on the investment. Unless you have a long-term investment, you would need to use your marginal tax bracket percentage (but I used 20% to go easy on the investment alternative).
One also needs to earn a “Risk Premium” on the (no guarantee) investment. No investment comes with zero risk, there are ways to mitigate or reduce risk (and then AIG happens). Guarantees require a counterparty, and they require payment to accept risk. Suppose the effective cost for risk is 10% (can you really get a high rate of return with low risk? read about ‘beta’ and ‘alpha’), but it is probably closer to 25% (long-term).
Then you need to earn more than the net Rate of Return,
Or
depending upon your investment risk, you may need to earn 5.5-6.5% to break even on return. And it isn’t worth the trouble to break even, so you want to earn something (hence the ‘>’ sign), suppose that you want to earn 10%-20%, how much higher must RoR be? [Exercise for the reader: what is needed RoR at 20% tax, 25% risk, and 20% earnings?]
Since you bought a house and paid cash, suppose you want to buy a rental property? Now you can buy that rental using leveraged money (it is an investment), and it is easier to borrow, because you have a lower debt to income ratio.
The safest investment you might buy is a Money Market, FDIC insured to $250K, which pays what rate? What is the current rate being paid by A* rated bonds?
Do you know how many days over the past 100 years the stock market average (which beats 80% of professional mutual fund managers) has closed up over the previous day (and how many days it has closed down)?
My question here is do you want to buy the house as an investment or a place to live?
I am in London UK and own a house.
I wish to move.
I have found probably three places I would like to move to in four years, in each case, before I could complete the sale process, a cash buyer turned up within a week and completed the sale.
Sale buying chains can take months.
I would suggest that, if you can do an outright purchase, that you find a place you want to live in for whatever reason.
I have considered let to buy and buy to let for financial reasons but my own home is the place I wish to live in.
Very true.
You do not give your age or where the money comes from.
A very common problem with inherited wealth is to spend too much without making provision for maintenance/unexpected problems.
Having enough cash to buy a property outright is a huge advantage , you can always remortgage later if conditions allow.
One possible eason is flood insurance. Say you buy a property where the land is worth more than the house. The mortgage lender will, at least in my experience, require you to carry flood insurance for the outstanding balance of the mortgage, rather than replacement value of the house.
PS: To elaborate a bit, you need to look at the total cost of the mortgage, not just the stated interest rate. There are often various costs tacked on, like PMI if you’re buying with less than 20% down, or in my case, required flood insurance coverage that was well above the house’s replacement cost. (And of course there are possible benefits, like deductible interest.) In my case, the original 4.5% mortgage was effectively closer to 6%, which meant it was (at times) more reasonable to pay down the mortgage rather than invest in what I thought* was an overheated market.
*Correctly, as it turned out, as the times were around 2005-07.
You can buy a house in cash, then immediately set up a HELOC (“home equity line of credit”, a common type of loan offered by banks and mortgage companies that is backed by home equity, that does not require you to incur the debt or accrue interest until you draw on the line of credit, typically with a checkbook or debit card issued to you) to maintain liquidity, getting the best of both paths.
I think you have a misunderstanding in point 2:
No, the rate of your loan is how much interest you pay relative to the outstanding balance. In the first year of a mortgage with a constant monthly payment, yes, you pay more interest (as a percentage of your payment) because your outstanding balance is higher. You will pay slightly less than 3.5% of your loan balance in interest over the first year (it’s slightly less because you’re gradually reducing your principal amount as well).
So yes, you can earn more than 3.5 on average by investing in equities than you pay in mortgage interest.
Where the difference comes is risk. Paying off debt (including a mortgage) is effectively a risk-free investment, since your interest rate is guaranteed. Gains in the stock market are not guaranteed. Some years you’ll gain 30-40%, some years you’ll lose 30%. When the investment is borrowed and tied up in a house, a market crash can bring a seemingly fool-proof plan to its knees. When your house is paid for, you have no worries about losing the house in a bear market.
(I’d bet that many “smart investors” lost their homes in 2008 when their leveraged investments cratered)
Another difference is liquidity. If your house is tied down by a mortgage, then it is harder to sell, risks being underwater if the market value decreases, etc. Cash flow is also important as you will be required to make a mortgage payment each month. If you get into a cash crunch you might find yourself tapping the investment, reducing future gains and triggering potential capital gains taxes.
It is true you might get a tax deduction for mortgage interest (although you are correct that there’s a bigger chance now that you won’t be able to itemize), however you can also get a tax deduction by investing money in tax-advantaged accounts such as retirement accounts and education IRAs.
A wiser plan would be to pay cash for the house, invest the amount you would be spending on a mortgage, let it grow, and sleep easy.
Ask them if you already owned the house, would they be advising you to take out a mortgage in order to invest elsewhere. If not, ask them to explain the difference between taking out a mortgage on the day you buy the house and taking the same mortgage out the day afterwards.
I think you’re right.
However… unless (1) you’re very rich, or (2) the house is very cheap, or (3) you’re buying one house with the proceeds of another, then buying with cash is going to wipe out a significant percentage of your liquidity.
That’s why I’d get a mortgage, and plan on paying it off in 10 years.
EDIT: Life is a balancing act, and becoming cash poor is almost as out-of-balance as being in hock up to your eyeballs.
What reasons are there to not use a loan? Handful of thoughts off the top of my head (Cleaned up to highlight the “Risk” aspect and simplify):
Risks – Are you looking for more risk than a bank will “Support”? Want the edge in a bidding war? Cash only, no inspection, no paperwork – stuff that others who go through loans will have to tackle while you can simply sign?
Costs – in addition to the 3.5%, there are tons of other “costs” that mean you need to make “more” than the 8% to break even. From closing costs to taxes on that 8% you make. From inspection fees to late fees. All costs you need to factor in vs the “investment” options available that you may or may not get.
Other similar lists exist, such as this penny hoarder article
I think it’s important to look at numbers.
Let’s consider a $100,000 house.
Case one: Buying with cash
In this case, the risk is having all your eggs in one basket. Many people use the term “investment” when mentioning houses, but that’s debatable. Rental properties are an investment. Primary residences? I’d personally say no. There is nothing that requires the value of your home to go up. If it turns out that next year your house is worth $100,000, then you’re already losing money due to inflation. If the value goes down you lose even more. At the end of 15 years with no additional investing, you merely have the value the house, regardless of whether it went up or down.
Case two: 20% down payment
Let’s say you put $20k down and invest $80k. You get a 15 year loan for the $80k you still owe on the house, at 3.25%.
Over the course of the loan you pay $102k total (rounding up). So $22k in interest.
Let’s assume the $80k investment earns 8% annually. After 15 years that will grow to $234k
Evening things out
In case 2, you can argue that your payments every month count as additional investment, which doesn’t exist in case 1. To make things fair for case 1, let’s say you invest $450 a month, or $5400 annually. I’m too lazy to break it down by what the amortization schedule says. Invested as a lump sum yearly and gaining the same interest as the investment in case 2 (8%), this comes out to $147k. $87k less than what your investment does in case 2.
So you saved yourself the cost of $22k in interest, and missed out on earning $87k. Or the reverse for case 2 where you accept the $22k as a risk, and you’re betting your returns over 15 years is greater than that amount. As long as the markets do better than your interest rate, the large up-front investment always fares better.
Conclusion
Ultimately it comes down to the ‘day after’ you buy the house. In case 1 you have a house and no investments. In case 2 you have a large investment that is immediately ready to grow. Mathematically speaking, the investment will always win as long as your annual return is greater than your annualized interest rate on a loan. This is also why many people on this site don’t recommend paying off a 1.7% car loan early, and to instead put those extra funds into investments, because beating 1.7% annually is pretty easy outside of recessions/depressions.
Edit
If you want to take capital gains into consideration, the situation is a bit different. For this set of numbers I’ll use a more conservative 5% for the annual return, and assume the max capital gains of 20%.
Case 1:
Case 2:
Through ‘guess and check’, I found you’re able to still beat the $22k interest with a rate of only 3.8%. I tried using the annualized amortization schedule numbers, and the rate can go as low as 3.4% in that case.
And the caveat to all of this is: OP is the only one who knows the real numbers/rates. 10 year loans have even lower rates than 15 year loans. It could be that OP is looking at a $600,000 house in which case all of these numbers get bigger, but the math still works out the same.
This just underscores my point: whether OP is willing to take the risk of getting a mortgage and investing or wants to buy the house outright is up to OP. However, the two situations only look close in my answer because I’m trying to be fair and assuming the OP can save $400+ per month. It’s reasonable to think OP can, because they won’t have a mortgage payment, but if we go any further it’s all speculation. OP can decide for themselves which risks are acceptable or not.