Why is it better to buy a home with a mortgage even if you can buy it off in full?
In: Economics
Depends on your interest rate. If it’s low enough you can beat it with investments. If your interest rate if high, then the less debt the better.
My interest rate is 3.5%, long term stock gains would be taxed at 15% (and no state tax) so to beat it I just need to average better than ~4% each year, which for the S&P 500 is very easy over the long run.
Oh, if you itemize your tax deductions then that also would be a factor.
Aside from the investment angles, it also helps to establish good credit scores. Your credit score is based off of multiple factors, one of which is your ability to make payments on time with regularity. Nothing is more regular than a mortgage. If you have a long history of paying your mortgage in time, lenders are more likely to give you favorable terms in order to work with them.
It isn’t always necessarily true.
But it just has to do with the mortgage interest rate vs the possible rate of return you could make on investing your money.
Like say you go to buy a house, and you have the option for taking a $100,000 mortgage and investing your money, or just paying for the house in full.
If you decide to pay for the house in full, great, you won’t have to pay any interest anywhere so you are “saving” that potential extra money spent.
But let’s say you take out the 100k mortgage at a 7% interest rate. And invest your 100k cash. At the end of the year you will now have a total mortgage of 107k because of the 7% interest accrued.
But, if your investments went up by 8%, then your investment account now has 108k in it. Meaning even though you are paying interest, you still made $1,000 by just investing your money.
This becomes doubly true when interest rates are low, like 5% or lower, because that’s easier for investments to beat.
It might be better for YOU the buyer to buy a necessity like a house on credit, but in a “free” market you shouldn’t be there. You are a buyer that does not exist without credit, and thus increase the price of housing without the ballast of collateral. In short, you deprive others of necessities because you can refuse to work for the things you have.
So my wife and I recently paid off our house. No credit cards, no car payments. I went to get a new car, in in that 6 months, our credit dipped to the lowest it’s been since we were in our 20s. I’m not saying don’t do it, I’m no financial advisor, but something to keep in mind.
Depends on your interest rate, the time you plan to hold onto the home, and what you could do with the cash if you don’t spend it on a house.
Let’s take an easy example – $100K house, you have $100K+ in cash you could use to purchase the house outright, you plan to hold the house for 5-10 years.
So if you spend $100K on the house, that’s that. All $100K is tied up in the house. If you sell in 5-10 years for $150K, you made $50K on a $100K investment. 50% – that’s not bad. But if you put down $20K and financed $80K when you first bought, then when you sold, you made $50K on a $20K investment, a 250% return. This ignores your borrowing costs for the moment, but even if you assume you pay $20K in borrowing costs, you still end up making $30K on a $20K investment, or a 150% return. You can calculate all of this precisely based on particular rates and terms, but these examples should give you an idea of why it’s often a good idea to use other people’s money when paying for your stuff that you can resell later. It’s called leverage, and it’s an extremely powerful tool for taking modest returns and making them much higher. There’s risk with leverage of course, but if you have the cash at the outset, your risk is small so long as you don’t lose it.
Leaving that aside, if you can borrow money for significantly less than what you can (more or less) safely earn on it, it’s a good idea to borrow that money as long as you actually invest the cash you didn’t need to use on the house. You need to know your likely rate of return and what your taxes will look like to determine how valuable this approach is, but generally speaking the lower your interest rate, the more attractive this option becomes.
It isn’t.
Imagine your house, worth 200k, is paid off.
Would you borrow against your house in order to invest in stocks or mutual funds or whatever?
There’s your answer.
Opportunity cost is the phrase you’re looking for. As in : if I spend money on a home, I give up using that money somewhere else. Mostly depends on the cost of money (interest rates) and the alternative return.
Example: my mortgage is very low rate (2.6%). I spend $400 month/$100k borrow on principal + interest, about $5k/year.
If I had $100k and could get 5% on a CD, the interest generated would pay for my mortgage without the loss of principal.
Or I could invest in the market and get 7% while only paying 2% interest.
Today’s mortgage rates make these options less viable.
As others have said, it is not necessarily better for everyone.
Unlike other types of interest, like that from a savings account, mortgage interest is “amortized.” This means that in the first 10 years of a 30 year mortgage, pretty much *all* of your mortgage payments goes towards the interest you would have paid over the full 30 years. Because the bank wants their money sooner. Sell your house after 10 years, you’ll still owe the bank pretty much the same amount if you sold it after 2. If that sounds like a ripoff to you, you won’t hear me argue.
But! In exchange for paying your mortgage on a regular basis, your credit score goes up. Which means … banks will be more willing to loan you *even more money* in the future, because you’ve proven yourself a “good customer” for their interest collection services.
At my age and in my opinion, if I can buy anything without giving banks any more of my money, I will choose it.
If it is a rental you can use the rental income to pay down the mortgage, raising your net worth over time.
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