Pros and Cons of Paying Cash for a House
April 22, 2002, Rewritten February 5, 2007, Revised
August 22, 2010
An all-cash home purchase should be viewed as a "no-mortgage" investment. The return is the interest rate you would otherwise have paid on the mortgage but now avoid. This return can be compared to that of other investments in terms of return, risk and liquidity. To make valid comparisons, however, it must be assumed that the house purchaser who elects a no-mortgage investment saves an amount every month that is equal to the payment he would have had to make had he taken the mortgage. The mortgage is a forced-saving device.
"My wife and I are both in our late 20s and would like to buy a home for $250,000. We have $500,000 in available assets, including cash, stock, and bonds, as well as $100,000 in retirement assets. We have no debt. We can afford to pay cash for the home. Should we? What should we consider in making that decision?"
An all-cash purchase should be viewed as an investment. The investment is not the house, because you are buying the house, and will enjoy any appreciation in its value, whether you pay all cash or take out a mortgage. The investment in an all-cash transaction is the mortgage you avoid. It might be called a "no-mortgage" investment.
Suppose, for example, the alternative to an all-cash transaction is a $200,000 mortgage at 8.5% with no additional costs. If you pay the $200,000 in cash instead, your return on that cash is the 8.5% that you would have paid on the mortgage.
In considering whether investment in the no-mortgage is wise, you compare it to your other investments with respect to three things: return, risk and liquidity. The no-mortgage investment has a return of 8.5%, it is risk-free, and it provides some but not high liquidity. Since your home would have no liens on it, you could easily obtain cash in a few days with a home equity loan.
Compare this investment to your other assets. Your cash assets carry a lower return, probably have very low risk, but offer the highest liquidity. You want some of your assets in this form, but not more than you need for every day use and for emergencies.
Your bonds may have a higher or lower return, depending on their risk category. Adjusted for risk, however, they are an inferior investment to the no-mortgage. Only US Government bonds are risk free, and they yield 1-2% less than the no-mortgage. Furthermore, bonds are not very liquid in the small amounts you would sell. I prefer the no-mortgage over bonds.
Stocks in contrast generally earn a higher return than the no-mortgage, but they also carry the risk of price fluctuations. You are young and can afford to have stocks comprise a significant portion of your portfolio. But also because you are young, you have no experience with protracted declines in the stock market, and might be inclined to overdo it.
If I had your portfolio and was your age, I think I would hold about $50,000 in cash assets, $200,000 in a diversified portfolio of common stock, and a mortgage-free house. But that's a "conservative" portfolio, and no doubt it is influenced by the fact that I am not in fact your age.
"In a recent article, you said that paying all cash for a house made sense if the investment return on the cash was lower than the mortgage rate. But my numbers show otherwise. I am currently earning 5.5% on 200K invested in a money market fund, and the mortgage offered me has a rate of 7.75%. If I pay cash for the house, I save $315,818 in mortgage interest over 30 years. But if I take the mortgage and invest the 200K at 5.5%, after 30 years I have $1, 037, 478. Is there something wrong with my logic?”
Yes. Comparing interest payments in one case with future wealth in another is comparing apples and oranges. You should compare future wealth in one case with future wealth in another.
Furthermore, you’re forgetting that if you take the mortgage, you must make monthly mortgage payments to the lender of $1432.83, whereas if you pay cash, you don’t make these payments.
Your calculation that you would have $1,037,478 after 30 years if you take the mortgage and invest the 200K at 5.5% is correct. Your wealth in the all-cash transaction is the value of $1432.83 invested every month in the money market fund. This turns out to be $1,309,051. You will have more wealth if you pay cash, which is consistent with the principle that paying cash is preferable if the return on investment is below the mortgage rate.
But this example reveals an important proviso: to be better off in the future from paying cash, you must invest the same monthly payment that you would have made if you had borrowed. With the mortgage, you don't have to think about this because you must make the payment, but without the mortgage it becomes voluntary. If the $1432.83 you pay the lender in the mortgage case is spent in the all-cash case, you will end up substantially poorer paying all-cash.
Some time after writing this article, I developed a spreadsheet called Future Net Worth, which can be downloaded to your computer. The spreadsheet allows you to measure your future net worth on the assumption that you pay all cash, then measure it again on the assumption that you take a mortgage, and see where you end up in each case. The spreadsheet calculates your net worth year by year in both cases. I will illustrate with a simple example. I assume you are purchasing a house for $180,000 and your nest egg also amounts to $180,000. You can use the nest egg to pay for the house, or you can leave it untouched and borrow the $180,000. [Of course, the spreadsheet also allows any combination in-between, such as making a 20% down payment from the nest egg and borrowing the balance.] The loan would be a 30-year fixed-rate mortgage at 6% with a monthly payment of $1079.20. I assume that you have $1500 of income on top of that available for investment.
Hence, if you take the mortgage, you have $180,000 plus $1500 a month to invest. If you pay all cash, you have no lump sum to invest, but you do have $2579.20 a month to invest. (This is the $1500 plus the mortgage payment of $1079.20 you won’t be making). I assume you are in the 28% tax bracket, which provides a tax saving on the mortgage interest, and a tax payment on the investment income.
The most important determinant of the outcome is the assumed rate of return on investment compared to the mortgage rate. For example, if you earn 6% on your investments, matching the rate you pay on the mortgage, your net wealth after 15 years is $831,602 if you borrow the $180,000, and $831,599 if you pay all cash. If the rates are the same, future wealth will be the same -- the trivial difference I found is a rounding error.
These numbers understate the actual wealth you would have because I have assumed zero property appreciation. Since the future value of the house will be the same regardless of how you finance the purchase, appreciation has no bearing on which mode of financing is better.
Now lets assume that you can earn 9% on your investments. This is a reasonable assumption if you invest in a diversified portfolio of common stock. It is an appropriate assumption if you are young enough to have a long time horizon, and can maintain an equable disposition in the face of short-run fluctuations in your wealth. On this assumption, your wealth after 15 years would be $ 1,049,897 if you borrow compared to $961,556 if you pay all cash.
Rule number one is simple: if the rate of return on your investments exceeds the mortgage rate, borrowing leaves you better off than paying all cash.
Now lets assume that you earn only 4% on your investment. This is a reasonable assumption if you have an extremely conservative investment policy, a relatively short time horizon, or both. You have guessed correctly that you will do better paying all cash in this situation. After 15 years, your wealth would be $759,824, compared to $716,727 if you borrow.
But, there is an important proviso. My calculation assumes that if you pay all cash for the house, you invest (at 4%) the $1079.20 per month you would have paid on the mortgage. If you spend it instead, your wealth after 15 years will be only $517,211, or much less than if you had borrowed, despite the fact that the borrowing rate exceeds the investment rate. The mortgage forces you to save whereas the all-cash strategy doesn’t.
Rule number two includes the proviso: if the rate of return on your investments is less than the mortgage rate, paying all cash leaves you better off than borrowing, provided you save an amount every month equal to the mortgage payment that you would have had following a mortgage strategy.
An all-cash home purchase should be viewed as a "no-mortgage" investment. The return is the interest rate you would otherwise have paid on the mortgage but now avoid. This return can be compared to that of other investments in terms of return, risk and liquidity. To make valid comparisons, however, it must be assumed that the house purchaser who elects a no-mortgage investment saves an amount every month that is equal to the payment he would have had to make had he taken the mortgage. The mortgage is a forced-saving device.
The No-Mortgage Investment
"My wife and I are both in our late 20s and would like to buy a home for $250,000. We have $500,000 in available assets, including cash, stock, and bonds, as well as $100,000 in retirement assets. We have no debt. We can afford to pay cash for the home. Should we? What should we consider in making that decision?"
An all-cash purchase should be viewed as an investment. The investment is not the house, because you are buying the house, and will enjoy any appreciation in its value, whether you pay all cash or take out a mortgage. The investment in an all-cash transaction is the mortgage you avoid. It might be called a "no-mortgage" investment.
Suppose, for example, the alternative to an all-cash transaction is a $200,000 mortgage at 8.5% with no additional costs. If you pay the $200,000 in cash instead, your return on that cash is the 8.5% that you would have paid on the mortgage.
Comparing Alternative Investments
In considering whether investment in the no-mortgage is wise, you compare it to your other investments with respect to three things: return, risk and liquidity. The no-mortgage investment has a return of 8.5%, it is risk-free, and it provides some but not high liquidity. Since your home would have no liens on it, you could easily obtain cash in a few days with a home equity loan.
Compare this investment to your other assets. Your cash assets carry a lower return, probably have very low risk, but offer the highest liquidity. You want some of your assets in this form, but not more than you need for every day use and for emergencies.
Your bonds may have a higher or lower return, depending on their risk category. Adjusted for risk, however, they are an inferior investment to the no-mortgage. Only US Government bonds are risk free, and they yield 1-2% less than the no-mortgage. Furthermore, bonds are not very liquid in the small amounts you would sell. I prefer the no-mortgage over bonds.
Stocks in contrast generally earn a higher return than the no-mortgage, but they also carry the risk of price fluctuations. You are young and can afford to have stocks comprise a significant portion of your portfolio. But also because you are young, you have no experience with protracted declines in the stock market, and might be inclined to overdo it.
If I had your portfolio and was your age, I think I would hold about $50,000 in cash assets, $200,000 in a diversified portfolio of common stock, and a mortgage-free house. But that's a "conservative" portfolio, and no doubt it is influenced by the fact that I am not in fact your age.
An Important Proviso: The Mortgage as a Forced Saving Device
"In a recent article, you said that paying all cash for a house made sense if the investment return on the cash was lower than the mortgage rate. But my numbers show otherwise. I am currently earning 5.5% on 200K invested in a money market fund, and the mortgage offered me has a rate of 7.75%. If I pay cash for the house, I save $315,818 in mortgage interest over 30 years. But if I take the mortgage and invest the 200K at 5.5%, after 30 years I have $1, 037, 478. Is there something wrong with my logic?”
Yes. Comparing interest payments in one case with future wealth in another is comparing apples and oranges. You should compare future wealth in one case with future wealth in another.
Furthermore, you’re forgetting that if you take the mortgage, you must make monthly mortgage payments to the lender of $1432.83, whereas if you pay cash, you don’t make these payments.
Your calculation that you would have $1,037,478 after 30 years if you take the mortgage and invest the 200K at 5.5% is correct. Your wealth in the all-cash transaction is the value of $1432.83 invested every month in the money market fund. This turns out to be $1,309,051. You will have more wealth if you pay cash, which is consistent with the principle that paying cash is preferable if the return on investment is below the mortgage rate.
But this example reveals an important proviso: to be better off in the future from paying cash, you must invest the same monthly payment that you would have made if you had borrowed. With the mortgage, you don't have to think about this because you must make the payment, but without the mortgage it becomes voluntary. If the $1432.83 you pay the lender in the mortgage case is spent in the all-cash case, you will end up substantially poorer paying all-cash.
Using My Future Net Worth Spreadsheet
Some time after writing this article, I developed a spreadsheet called Future Net Worth, which can be downloaded to your computer. The spreadsheet allows you to measure your future net worth on the assumption that you pay all cash, then measure it again on the assumption that you take a mortgage, and see where you end up in each case. The spreadsheet calculates your net worth year by year in both cases. I will illustrate with a simple example. I assume you are purchasing a house for $180,000 and your nest egg also amounts to $180,000. You can use the nest egg to pay for the house, or you can leave it untouched and borrow the $180,000. [Of course, the spreadsheet also allows any combination in-between, such as making a 20% down payment from the nest egg and borrowing the balance.] The loan would be a 30-year fixed-rate mortgage at 6% with a monthly payment of $1079.20. I assume that you have $1500 of income on top of that available for investment.
Hence, if you take the mortgage, you have $180,000 plus $1500 a month to invest. If you pay all cash, you have no lump sum to invest, but you do have $2579.20 a month to invest. (This is the $1500 plus the mortgage payment of $1079.20 you won’t be making). I assume you are in the 28% tax bracket, which provides a tax saving on the mortgage interest, and a tax payment on the investment income.
The most important determinant of the outcome is the assumed rate of return on investment compared to the mortgage rate. For example, if you earn 6% on your investments, matching the rate you pay on the mortgage, your net wealth after 15 years is $831,602 if you borrow the $180,000, and $831,599 if you pay all cash. If the rates are the same, future wealth will be the same -- the trivial difference I found is a rounding error.
These numbers understate the actual wealth you would have because I have assumed zero property appreciation. Since the future value of the house will be the same regardless of how you finance the purchase, appreciation has no bearing on which mode of financing is better.
Now lets assume that you can earn 9% on your investments. This is a reasonable assumption if you invest in a diversified portfolio of common stock. It is an appropriate assumption if you are young enough to have a long time horizon, and can maintain an equable disposition in the face of short-run fluctuations in your wealth. On this assumption, your wealth after 15 years would be $ 1,049,897 if you borrow compared to $961,556 if you pay all cash.
Rule number one is simple: if the rate of return on your investments exceeds the mortgage rate, borrowing leaves you better off than paying all cash.
Now lets assume that you earn only 4% on your investment. This is a reasonable assumption if you have an extremely conservative investment policy, a relatively short time horizon, or both. You have guessed correctly that you will do better paying all cash in this situation. After 15 years, your wealth would be $759,824, compared to $716,727 if you borrow.
But, there is an important proviso. My calculation assumes that if you pay all cash for the house, you invest (at 4%) the $1079.20 per month you would have paid on the mortgage. If you spend it instead, your wealth after 15 years will be only $517,211, or much less than if you had borrowed, despite the fact that the borrowing rate exceeds the investment rate. The mortgage forces you to save whereas the all-cash strategy doesn’t.
Rule number two includes the proviso: if the rate of return on your investments is less than the mortgage rate, paying all cash leaves you better off than borrowing, provided you save an amount every month equal to the mortgage payment that you would have had following a mortgage strategy.
Warning to All-Cash Buyers!
The house you purchase is likely to have a mortgage on it. If you take out a new mortgage to fund your purchase, the new lender will make sure that the old mortgage is paid off. But if there is no new lender, you must do this yourself to make sure you are getting a lien-free property.
If you don't, you can be in for a nasty surprise. I have letters from all-cash buyers who were burned by sellers who took their cash and promised to repay their mortgage, but didn't. To avoid foreclosure, these buyers were later forced to assume responsibility for these mortgages. Don't let that happen to you.