Laura answers a listener's question about getting a mortgage to buy a home or saving cash to buy one outright later.
Laura answers a listener's question about getting a mortgage to buy a home or saving cash to buy one outright later.
Money Girl is hosted by Laura Adams.
Transcript: https://money-girl.simplecast.com/episodes/should-i-get-a-mortgage-or-save-to-pay-cash-for-a-home/transcript
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Sandy from Hopkinsville, Kentucky, who says:
"I'm 31, max out a Roth IRA, have a 6-month emergency fund, and no debt. I have about $1,000 left each month, and I want to invest it in diversified ETFs in a brokerage account. I'm looking for at least a 7% return over the next ten years, which would allow me to pay cash for a house. I don't want to pay interest to a lender when I can get the interest instead.
I plan to live in the house and flip it, claiming the capital gains tax exclusion after five years. But I'm in no rush if the housing market is down in ten years. What do you think: should I pay cash or get a mortgage for a home? I love the podcasts and have listened to all of them!"
Thanks for your great question, Sandy! I love that your finances are so great for being so young. Today, I'll review the pros and cons of getting a mortgage to buy a home sooner or waiting to pay all cash later. While there isn't a right or wrong answer, there's much to consider when making such a big financial decision.
Thanks for downloading episode 929 of the Money Girl podcast! I'm Laura Adams, an award-winning author, money speaker, on-camera spokesperson, and founder of The Money Stack, a Substack newsletter. You can subscribe for free or become a paid member with access to live educational events!
You can learn more and connect with me at LauraDAdams.com. That's also where you can email your money question, learn more about my books and courses, and sign up for The Money Stack. You can also record a brief question or comment on our voicemail
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What are the benefits of paying cash for a home?
In a perfect world, paying cash for a home would be easy, and no one would have to pay interest to a mortgage lender. If you can pay cash for a home, here are five benefits of owning it outright from the start.
1. You have no mortgage payments: As Sandy mentioned, not paying interest to a lender means you save a lot. Mortgage rates are currently near 7%. Depending on how long you own a home, avoiding mortgage interest could save hundreds of thousands of dollars.
2. You have fewer closing costs: Owning a home outright means avoiding many mortgage-related closing expenses, including origination fees, appraisal fees, and private mortgage insurance (if your downpayment is less than 20%).
3. You may have a stronger negotiating position: A seller might prefer to accept a lower cash offer than a higher one contingent upon getting mortgage approval. That would eliminate any risk of financing falling through. However, your negotiating strength depends on the local housing market and a seller's situation.
4. You can close a home faster: Paying cash for a house means you could close faster compared to a deal contingent on getting a mortgage. You won't have to wait for loan underwriting or a home inspection, appraisal, survey, or any service typically required by a lender. You could close within days instead of several weeks at a minimum.
Note that even if you buy a home with cash, it's still wise to have various inspections to ensure the property doesn't have invisible but needed repairs.
5. You never have foreclosure risk: When you don't owe a lender for your home, you don't have to worry about missing mortgage payments if you experience financial hardship, like losing your job or business income. However, if you don't pay vendors that work on your home or taxes, you could still lose your home through an unpaid lien.
READ ALSO: The right time to pay off your mortgage
What are the downsides of paying cash for a home?
Even if you can afford to pay cash for a home, here are four downsides to consider.
1. You may miss appreciation: Sandy mentioned needing to wait ten years before her investments would grow enough at a 7% return to afford a home. During that time, I assume she'd have to pay rent and wouldn't benefit from any potential appreciation in the real estate market.
Sandy said she was in no rush and implied that she might decide not to buy a home if the housing market is down. Remember that purchasing a home when prices are low is the perfect time to become a homeowner because you'll likely enjoy more appreciation over the long run. While homes appreciate an average of about 5% annually, there’s short-term volatility in the housing market.
2. You risk spending more: If you or Sandy wait to buy a home until you can pay for it solely with cash, prices could be significantly higher than today. That means the amount you save might not be enough to buy the home you want.
3. You have less liquidity: If a large portion of your net worth is tied up in your home, that lack of diversification could be risky if the housing market plummets.
4. You can't claim a significant tax deduction: If you itemize deductions on your tax return, homeowners can claim the interest paid on a mortgage, up to a limit, as a tax-deductible expense.
RELATED: Should I pay down my mortgage early to eliminate PMI?
What are the benefits of getting a mortgage for a home?
Even if you can pay all cash for a home, it can make sense to keep more of your money and take out a mortgage instead. Here are three benefits of financing real estate.
1. You can build equity sooner: When you buy a home, even with a mortgage, you'll likely enjoy appreciation as the housing market gets more valuable. That builds equity you can tap or roll into your next home purchase.
2. You can invest more: Instead of using more cash to buy a home, you can use a smaller amount for a down payment and closing costs and invest the rest. That could give you a higher return than the after-tax interest rate you'd pay on a mortgage, but it's never guaranteed.
3. You have more liquidity: When you keep more cash, you can boost your emergency fund, invest more, or reach other financial goals. A mortgage can give you more flexibility and avoid being "house rich and cash poor."
LISTEN ALSO: Is buying an affordable home still possible?
What are the downsides of getting a mortgage for a home?
1. You pay interest: Of course, the biggest downside of a mortgage is that you must pay interest, which increases your total cost of homeownership over the life of the loan. Monthly mortgage payments are typically a homeowner's largest expense.
2. You pay more closing costs: As previously mentioned, taking out a mortgage adds various expenses to the amount you must pay for a home at the closing. Plus, you must pay private mortgage insurance if you make less than a 20% down payment.
3. You have foreclosure risk: If you can't pay a mortgage, your lender could sell your home in foreclosure to satisfy the debt. That could leave you without a home and a severe black mark on your credit report.
LISTEN ALSO: How strategic debt elimination builds wealth faster
Is it better to get a mortgage or pay cash for a home?
Without knowing more about Sandy's financial situation, I'd recommend saving enough for a 20% down payment plus closing costs and getting a mortgage for her first home. That would allow her to buy a home faster, enjoy homeownership, and benefit from potential appreciation. If Sandy waits ten years to buy a property, prices could be significantly higher than today.
However, if Sandy's primary goal is avoiding debt and she's comfortable waiting ten years to buy a potentially higher-priced home, there's nothing wrong with that plan. Just be aware that you'll likely have most of your net worth tied up in one asset, which could plummet if the housing market declines.
Sandy also mentioned wanting to live in a home and flip it, taking advantage of the capital gains tax exclusion after five years. You only have to own and live in a home for two out of the five years before selling a home to claim the gains exclusion.
If fixing up and selling a home every few years is Sandy's goal, that tips the scales toward getting a mortgage instead of waiting to buy a home with all cash. When you plan to own a home for a short period, leveraging financing makes more sense than paying cash. Plus, Sandy would need money to make needed repairs and put the property back on the market, assuming that's her intent.
To sum up, no one can predict if you'd have a higher net worth after 30 years if you invested extra money instead of using it to pay for a home with all cash. You must weigh the pros and cons based on your financial situation and goals.
However, I do recommend remaining as diversified as possible to avoid the risk of any particular investment, such as real estate or an individual stock, losing significant value. Having your money spread into various investments is a wise way to cut risk and earn more, even accounting for the cost of mortgage interest.
If Sandy finances a home and decides to remain there long-term, she could always pay her mortgage off ahead of schedule. If she still has no other debt and regularly invests at least 10% of her income for retirement, that might be part of a sound financial plan.
Thanks again for the question, Sandy.
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That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
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