Over 30% of homebuyers pay cash when they purchase real estate. However, this may not be the smartest financial strategy. Here’s why:
When you pay cash for a property, you are missing out on the opportunity to earn a rate of return on that cash. In the illustration below, Option 1 is to pay cash for a $200,000 house. Option 2 is to use $100,000 of cash, and a $100,000 mortgage. If you go with Option 1, you’d be losing money by giving up the ability to earn a rate of return in an outside investment (such as stocks, bonds or another real estate property). If you go with Option 2, you’d be losing money by paying interest. You’d lose money either way.
| Pay Cash |
Use Mortgage |
|
| Funds Needed | $100,000 | $100,000 |
| Opportunity Cost % | 4% | - |
|
Opportunity Cost $ (what you would have earned by keeping your money invested) |
$4,000 | - |
| Mortgage Cost % (based on 4% mortgage APR) | - | 4% |
| Mortgage Cost $ | - | $4,000 |
These are the two questions you could ask yourself in order to find out which option would cause you to lose the least amount of money:
- Question #1: What would be my after-tax mortgage interest rate if I used a mortgage? In some cases, mortgage interest may be tax deductible. For example, a 4% tax-deductible mortgage for someone in a 25% income tax bracket may only cost 3% after-tax (4% minus 25% tax benefit = 3% after-tax cost). For more details, please see my article called, When is Mortgage Interest Tax Deductible?
- Quesiton #2: What would be my after-tax rate of return if I keep my cash invested? Please see a financial advisor for more details on this.
If your rate of return on investments is greater than the after-tax cost of a mortgage, it may make more sense for you to use a mortgage and keep your funds invested. Please contact me for more details, or if you’d like for me to run a cash vs. mortgage analysis for your situation.
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