Reader Question: Are there any benefits to paying cash for a home worth $200,000?
Monty’s Answer: This is an issue to which you would receive different answers depending on the disposition of the person answering the question. Leverage is the gold standard for most real estate investors. Many non-investors believe their home is not an investment and should be free and clear of a mortgage. Others pay cash for all property. The reasons these different philosophies prevail depend on a person’s risk tolerance, their life culture or experience, the motives driving the purchase, and their finances. Let us review these options.
Pay cash for all real estate
The main benefits to paying cash are no mortgage payment, no financing costs or interest expense, increase in bargaining power at purchase, greater peace of mind and high-quality collateral. These points add up to simplicity.
Finance only investment real estate
Financing investment real estate provides a vehicle to increase the return on your capital. If one utilizes a single-family home as a rental property that generates income, $200,000 could make a twenty percent down payment on five homes, assuming you wrap the closing costs into the loans.
Conceptually, if the local rental market supported a monthly rental value of one thousand dollars, one rental home with no mortgage would generate twelve thousand dollars annually, or a gross six percent return on $200,000, plus deductions allowed by the IRS, before income tax.
That same home with a twenty percent down payment of $40,000 with a fixed rate $160,000 mortgage for thirty years at five percent interest would generate $1700 annually on $40,000, or a gross 4.25 percent return on your investment, plus deductions allowed by the IRS. With the addition of mortgage interest and the rate of return calculation on $40,000, the net return would likely be greater if financed. You would still have $160,000 in cash available to buy four more properties. These points add up to complexity, more work, more skill, and more risk.
Finance all real estate
Were a person with $200,000 cash to mortgage the home and occupy it on the terms stated above, they would have a monthly payment of $858.91 plus real estate taxes and property insurance, but the mortgage interest and real estate taxes are a tax deduction against ordinary income. They would still have $160,000 in the bank. These deductions help home ownership as renters have few expenses to deduct from their taxable income.
Five considerations for cash versus finance
- The homeowner that chooses to pay cash for their home now has more disposable income. The choices they have on how to save, invest or spend are numerous. They see their home as a place to give their family a sense of community, create memories, enjoy privacy, and more, but not an investment.
- If you are buying the home as an investment and will not be occupying it, or if you intend on living in it for a short time, then renting it out and repeating the purchase process over and over again, financing is the preferred methodology.
- How long do you plan to own the home? If you have the cash and will only be there for three to five years, a mortgage and other selling expenses increase the chances any appreciation in value over those years will be diminished when you sell the home.
- Your financial circumstances, whether it be a high paying job, good savings habits, inheritance, or whatever your source of cash, are such that you can pay cash without concern for return or other personal reasons.
- Some homeowners see their home as an investment and taking advantage of leverage, the mortgage interest deduction, and that looking to increase the rate of return on their investment is logical. They can still embrace the same benefits as the non-investment minded folks, but with the added responsibility and risk a mortgage entails.
While real estate has produced many of America’s fortunes, others who started on equal footing, are not successful. Education, effort, and common sense are essential for real estate investing. Some real estate investors do well from the very beginning and build incomes and assets that allow them to go full-time or retire from their day job early. There is an article on the Dear Monty website that discussed common errors newbie investors encounter that you may find helpful.