In my counseling sessions, this question has been coming up quite a bit
lately. I understand that very few people would ever be in a
position to pay cash for a house instead of getting a mortgage, but
there are a few out there who have the cash to pull it off. Those
of you who have no choice but to get a mortgage, make sure you read my
articles What Kind of Mortgage to Get, and When Is It Time To Buy a House before making your decisions. For the rest of you, read on...
Too often, people get the idea that it is better to get a mortgage than
to spend their cash to buy a house. Occasionally, people come up
with this idea themselves, or someone else has told them it is the
financially clever thing to do. First of all, always consider from whom you are getting your financial advice.
I have heard the advice to always use the bank's money to buy a
house, come from broke people, wealthy people, accountants and
sometimes even financial advisors. The reasons given
for using a mortgage to buy a house, rather than paying cash,
generally fall under one or more of three categories:
The tax deduction for mortgage interest.
Getting a return on someone else's money (the bank's money in this case).
Getting ahead faster by keeping your own money and using someone else's to buy the house.
In my opinion, if you are in a position to do so, it is generally better to pay cash for a house than to
take out a mortgage. Let's look at the above reasons one by one
and see how I came to my conclusion:
Tax deduction for mortgage interest.
For this example, I'm going to use a $100,000 fixed mortgage at 7% for
thirty years which results in a payment of about $665 per month.
By the time the house is paid off, after thirty years, a total of
$239,508 will have been paid of which $139,508 is interest. Since
the balance of the mortgage goes down a little each month, I'm going to
take an overall average of $4,650 paid in interest per year.
Understand that the tax deduction you get on your federal income tax for mortgage interest is only a tax deduction, not a tax credit,
and only applies to the interest paid, not the entire mortgage payment.
A federal tax deduction is money on which you do not have to pay
taxes. A tax credit, on the other hand, comes right off of your
taxes dollar for dollar. What is taken out of your paycheck is a
tax credit; therefore, you get it subtracted from what you owe on your
taxes in April. The tax deduction you get for mortgage interest
is only what you would have paid in taxes on the mortgage interest
amount. I know that this can all be very confusing, so let's just
go through the example.
If your tax bracket is 25%, that means that you owe the government 25%
of whatever you make after deductions. So, with the mortgage
interest, you save what the taxes would have been on that money.
In this case, you save 25% on the $4,650 you paid in mortgage
interest. Thus, your taxes drop by .25 x $4650 =
$1,162. In other words, without the mortgage interest tax
deduction, you would owe $1,162 more in taxes at the end of the year.
So, in this example, you are sending the bank $4,650 every year so that you don't have to send the government $1,162.
If you really want such a deal that badly, I'll give you the same kind
of deal: You send me $4,650 every year and I'll send you back
Do you see now how, in this example, making mortgage payments for the
tax deduction doesn't make sense? You're paying more in mortgage
interest than you are getting back in taxes.
Now, what if you happen to be right on the edge between your current
tax bracket and the next one down. In that case, you could still
pay cash for your house and then make a $4,650 charitable contribution
each year and get the exact same tax results without the extra risk of
having the mortgage. And since I mentioned risk, let's go on to
the next 'reason' for always using a mortgage to buy a house.
Getting a return on someone else's money.
This reason goes something like this: If you can borrow the money
from the bank in the form of a mortgage and then invest it elsewhere at
a higher rate, you're getting a return on someone else's money.
Well technically you are, but you forgot to consider one
Let's use the same mortgage as in the above example and let's say that
you can get an 11% return in a good Growth Stock Mutual Fund.
That would mean that you are borrowing the money at 7% and
reinvesting it at 11% for an overall net return of 4%, right?
Well, not exactly. Don't forget that you have to pay taxes
on that 4% which knocks it down to more like 3%. You would be
personally liable for a $100,000 debt in order to earn a return of only
3% which doesn't even keep up with inflation. As long as
everything goes perfectly as planned, you can pretty much ignore the
risk (I guess) and go ahead and think that you are financially clever
for earning 3% on the bank's money. But, if just one thing goes
wrong such as getting laid off from your job, becoming disabled
and unable to work, getting sued over a car accident, or even a serious
illness in the family; you would be struggling to make a mortgage
payment you wouldn't have to make if you had paid cash for the house.
And if you think you would just pull the money out of the
investments and pay off
the mortgage balance, don't forget that in a financial crisis you're
need every penny you have. Besides, the market might be at a
cyclical low right at the time you need to pull the money out to pay
the mortgage. In that case, you might not even have enough to pay
the mortgage off completely. You might actually be cashing in
your investments at a loss! After doing these calculations, my
that the 3% return just isn't worth the risk of being in debt for that
Let's look at it a slightly different way. Let's look at what
happens if you go ahead and take out a mortgage to invest your money as
compared to what happens if you pay cash and invest what would have
been your house payments.
If we take out the mortgage, we can go ahead and invest our $100,000 at
the Growth Stock Mutual Fund historical average return of 11%. At
the end of the thirty year mortgage, our $100,000 will have grown
to $1,178,150 adjusting for taxes. During that time, we have paid
$139,508 in interest which we have to subtract out. That leaves
us with a total of $1,038,642 assuming nothing went wrong during
the thirty years we were paying on the mortgage.
If we instead use our $100,000 to pay cash for the house and then spend
the next thirty years investing the $665 per month that would have been
our house payment, we end up with a total of $1,042,865 after
The difference is so slight that it is not even really all that
significant after thirty years of investing. In other words, we
got to about the same place financially without taking all of the extra
risk of being in mortgage debt all of that time.
The only time that the argument of 'getting a return on someone else's
money' even sort of works, is if we assume that the investor has no regular
income. In that case, I guess a 3% return on someone else's
money is better than earning no money at all; but if you had no income,
you probably wouldn't be able to get the mortgage in the first place.
No matter what math a person uses to try to justify the strategy
of taking out a mortgage in order to invest, there is no way to make it
work unless you ignore the risk factor of being personally liable for
Getting ahead faster.
Do you really get ahead faster by taking out a mortgage instead of
paying cash for a house? Well, when I compared the time it takes
to earn back your original $100,000 using the banks money and the time
by paying cash for the house and investing what would have been your
payment; I found that investing what would have been your payment
actually gets your original $100,000 back in only fourteen years
compared to twenty four years when taking out a mortgage instead.
This was after adjusting for taxes and after subtracting out the
7% interest paid on the mortgage.
I am not a mathematician , so if anyone sees a
specific error in my math, or came up with radically different result
when doing the calculations, feel free to let me know.
But from what I have seen, and from all of the calculations I've
done, It sure seems to me that it would be better to pay cash for a
house than to take out a mortgage.
And if you factor in the possibility of:
Loss of income.
Reduction in income.
Increased personal expenses over time.
Personal financial emergencies.
Downturn in real estate values.
Just to name a few,
I would much rather be debt free
than be trying to earn 3% on the bank's money, or hoping for a tax
break that doesn't even work. If you think I might be wrong about
this, then please do the following: Go ahead and pay cash for the
house then each month put what would have been your mortgage payment
right into the bank and never touch it. Do this for no less than
five years. If after five years, you don't like where your
finances are headed, then you can still borrow against your house and
go into mortgage debt to get your money back out. Put it this
way: If your house were completely paid off and you were debt
free, would you go to the bank and borrow against your paid-for house
in order to invest the money? I hope not. But if you have
the cash to pay for a house and get a mortgage instead, that is exactly
what you're doing mathematically.
Questions to ask someone who advises you to not pay cash for a house.
If anyone ever tries to tell you that it is a better idea to mortgage a
house than to buy it for cash, ask them the following questions:
Are they wealthy or broke? (If they are broke, they shouldn't be giving you financial advice.)
Did they have cash available when they bought their house and, if so,
did they mortgage rather than pay cash? (In other words, have
they already tried it.)
Is their house currently paid for? If it is, why haven't they mortgaged
it to invest the money? (Shouldn't they be taking their own
If things went wrong, could they afford to take the financial hit?
(If they could take such a financial hit but you couldn't, why
would you risk it?)
Can they show you the legitimate calculations they used which show that
paying cash for the house is a bad idea? (Bet they can't!)
learn a lot more about saving, investing,
eliminating debt and
becoming wealthy, please read the articles
on the Financial Page.
There, you will find a veritable treasure of what to do and
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