There are some personal finance gurus that state you should always pay cash for a house. That way, you can avoid debt altogether. Any debt is bad debt is the common refrain. While it is certainly great peace of mind for some people not to owe money to any financial institution, in my view its not a good way to run your finances if you want to build wealth in the most efficient way. There are exceptions to this, such as someone who is older and wealthy and doesn’t want the hassle of getting a mortgage, or if interest rates are much higher than today’s rates. Another example would be someone that has no desire to invest excess funds. Some people prefer to leave excess capital in the bank or in CD’s, content with making returns below inflation in a large majority of cases. If that is someone’s preference, paying cash for a house makes sense considering that any excess capital will be making a lower return than the interest paid on a mortgage. Some people also prefer the peace of mind of owning their own home, which is fine, but does lead to much less wealth in the long run. For those willing to consider a wealth building alternative, read on….
One reason I don’t like paying cash for a house is that you are tying up a lot of money in something that is not likely to grow wealth much above inflation, if not below inflation. Even if you own a house in an area that is growing decently in population, jobs, and median income, you probably won’t see your home rise in value much over inflation in the long run. Many people have a hard time understanding this. For example, let’s say someone buys a home 30 years ago for $150,000. 30 years go by and it is now worth $364,000, good for a CAGR of 3%. If inflation runs at 3%, they haven’t gained any purchasing power. There money would buy the same amount of goods and services as 30 years ago. There are exceptions to this rule such as homes in San Francisco or Manhattan, but if you don’t live in a landlocked area with high demand, home prices aren’t going to rise dramatically over inflation in the long term. Contrary to popular opinion, owning a home is not the path to wealth, although in most cases it is much better than renting. I would argue that home ownership may preserve wealth, but if one is to grow wealth, business ownership and investment real estate are the vehicles needed to grow wealthy.
Instead of tying up a lot of your money in a house, it’s better to get a mortgage and invest the difference in a productive asset, i.e. something that produces income. For example, let’s say that a person has $300,000 saved up and wishes to buy a home. The person could pay cash for that $300,000 home, assuming they have the income to maintain it. A better option would be to purchase the home with 20% down and invest the difference. After down payment, closing costs, and a few months of mortgage payments saved up for emergency, the person would have around $225,000 left over. That person could pay cash for an investment property yielding 7% and have additional income of $15,750 per year pre-tax. Assuming they got a 30-year fixed rate mortgage at 4%, their annual mortgage payments would equal $13,750. Assuming a 15% total tax rate on the investment property income, (easily attainable after depreciation) it would give the person an after-tax rental income of $13,387, enough to cover the mortgage except for a few hundred dollars. Not only do you have an asset that almost covers the entire mortgage with cash payments in year one, the income and the value of the asset should also increase over time. If rents increase at 3% per year on average, (assume expenses increase 3% per year as well) after ten years the property will be yielding $21,667. However, due to the fixed rate of the mortgage, the yearly mortgage payments remain the same at $13,750. Assuming the same 15% tax rate, the property now yields $18,417 after tax, giving the person a difference of $4,667 to spend how they choose after paying the mortgage. Maybe they take a vacation, give to charity, help fund college education, etc. They now have some serious flexibility with their finances. Had they paid cash for the house after ten years assuming the same 3% appreciation rate, they would have a home valued at ~$403,000 but nothing else. No extra income, no other asset. With a mortgage, you would have the same house valued at $403,000, which you would still owe roughly $180,000, with home equity of $223,000. But you also have the investment property which is now worth ~$302,000 churning out $21,667 of pre-tax dollars. What’s more, you would have collected almost $186,000 of pre-tax income over those ten years. Current income and net worth would be MUCH higher under this scenario, rather than paying cash for the home. You would have no debt and the peace of mind of not owing anything to anyone, but it comes at a substantial opportunity cost to net worth and cash flow.
Of course some people will say, “That’s too optimistic, what if the property doesn’t appreciate or cash flow doesn’t measure up to expectations?” I would say the following: That could be right, the property may not perform as expected. There is always some risk in investing. If you pay cash for it, it’s very unlikely that you would lose money long term. Maybe you have some bad luck and have to replace a few Hvacs or a roof. Maybe vacancy is higher than expected and/or rents decline. Maybe the income from the property doesn’t fully cover the mortgage for a couple of years. I would say to make sure you have enough income or savings to handle some adversity. Before deciding to take out a mortgage and invest the difference, you need to decide if you are able to handle that financially and emotionally. In the real world, sometimes things don’t always go as planned. On the flip side, maybe the rental property performs better than expected, leading to even greater cash flow and net worth than expected. That scenario could happen as well.
Some astute risk tolerant investors may say, “Why would you say to get a mortgage on the house but not on the investment property? If everything works out, you will have far greater wealth than paying cash for the rental property.” That is certainly true, if you leverage the investment property and everything works out, your net worth will really explode. BUT, commercial loans are different from home mortgage loans. Leverage works great if things go as planned but can have devastating consequences if something goes wrong. If things do not work out and some unexpected disaster happens, you could not only lose the investment property but also your home if you do not have enough income or additional liquidity. Even worse, you could land in bankruptcy court if you can’t settle your debts. In my view, by leveraging the investment property you are introducing too much risk. Once again, it depends on a person’s appetite for risk and their financial situation. Using too much leverage has landed a lot of people in bankruptcy court over the years.
Another scenario would be to use the leftover money to buy stocks instead of investment property. Lets say you use the same $225,000 after down payment and closing costs to purchase an S&P 500 index fund. It would certainly grow nicely in value over the years but the income from it wouldn’t come close to covering the mortgage for quite a while. If the fund starts out yielding 2% that would only be $4,500 of pre-tax dividend income in year one. Even if it grows at an average of 6% per year, it would take almost 20 years until your pre-tax dividend income covered the mortgage payments. After taxes, it would take 22 or 23 years. This would be a great way of building net worth, but you would need to cover part of the mortgage with your income for a long time. If you chose this route, after 10 years you would have a home worth the same $403,000 with $180,000 left on the mortgage balance. Your S & P 500 index fund would coincidentally be worth $403,000 after 10 years if earnings averaged 6% growth per year and stocks had the same valuation as when they were bought (two big if’s, I know). You would have collected $62,872 in pre-tax dividend income and the fund would then be yielding ~$8,060, still a good ways short of the $13,750 in yearly mortgage payments. Of course, results could be better or worse, the future is never certain.
To me, either scenario is better than paying cash for the home. Both lead to significantly more net worth and income over time than by owning the home free and clear from the start. If after ten years you decide to sell the investment in order to pay off the mortgage, you would still have somewhere around $200,000 left over after paying the remaining mortgage balance. To me, it’s just too conservative and risk averse to pay cash for a house in the current low interest rate environment. If interest rates were to rise substantially and you were paying 8% instead of 4% then it may be wiser to purchase the home outright and forego a mortgage altogether. But in the current environment, 4% is a gift. Paying cash for a house may give someone peace of mind, but like everything there is an opportunity cost. For that peace of mind, you give up a lot of future income and net worth. An individual has to decide what is best for his or her personal situation.