What Every Prospective Homebuyer Should Consider
For most people, buying a home means going into debt to finance the purchase. However, if you’re fortunate enough to have the option to pay cash to buy a home, it’s wise to fully consider your options before taking the plunge. Just because you may have enough money to avoid taking out a mortgage, that doesn’t necessarily mean it’s the right move. It’s important to understand and carefully weigh the pros and cons of paying cash versus getting a mortgage to help prospective purchasers make the right decision based on their specific financial circumstances.
Benefits of a Cash Purchase:
Most of the benefits of paying cash (sans a mortgage) for a house are pretty obvious. First, you eliminate the burden of making a monthly mortgage payment and paying thousands and thousands of dollars in interest to a bank over the life of the loan. In addition, with no mortgage, your closing costs will likely be minimal, as mortgage lenders typically charge upfront fees and require prepayment of items like the current month’s interest at closing.
Some of the other benefits of paying cash aren’t quite as obvious. Except in special circumstances, lenders require homeowners to pay 1/12 of their anticipated property tax bill and homeowners’ insurance premium as a part of their monthly payment. Those funds are set aside in an escrow account, and they are disbursed to the appropriate taxing authority and insurance company when the tax bill and insurance premium come due. While that may seem like a nice convenience for homeowners, who then don’t have to worry about coming out of pocket each year for those expenses, avoiding the requirement to establish an escrow allows cash buyers to earn interest on their own money throughout the year. Assuming the cash buyer is disciplined about saving money for these expenses, the ability to control one’s own money and not have the mortgage company set aside escrow funds is arguably a better option.
If you know anyone who has obtained a mortgage loan in the last few years, you’ve probably heard horror stories about the application process. Regardless of how wealthy you are or how great your credit score is, borrowers should expect a great deal of scrutiny from loan underwriters. Borrowers should be prepared to comb through financial records to find obscure deposits and track down documents from years past. Think your strong organizational skills and impressive record keeping will make the process a cinch? Think again. Through the recent economic crisis, banks have reduced their workforce and shifted job responsibilities to already overwhelmed and overworked employees. As a result, today borrowers’ chief complaint about the mortgage application process is having to supply the same documentation to the same people on multiple occasions. Paying cash will alleviate that burden altogether.
Finally, some experts argue that buyers paying cash have a competitive edge in the market. For example, let’s say a property owner receives two offers to purchase his house. The first offer is strong from a price standpoint, but it’s contingent on the buyer obtaining a loan. The second offer is slightly lower, but it has no financing contingency. Observers report that, in that scenario, the cash offer prevails more often these days. In an uncertain market, sellers are attracted to a straightforward deal free of complications created by the mortgage loan application process, so this cash-is-king phenomenon is really catching on.
Benefits of Financing with a Mortgage Loan:
Conventional wisdom would probably dictate that all buyers who have the means to pay cash for their home do so, in lieu of getting a mortgage. Conventional wisdom, however, doesn’t take into account all the complexities of the issue. For example, if paying for the house out of pocket would exhaust your savings, perhaps it’s not the right move for you. Further, even if you would still be financially comfortable after a cash transaction, investing money in a house will tie it up. Therefore, if you want more flexibility or expect to need funds for other large purchases over time, getting a mortgage could be a better option.
In addition, with the lowest mortgage interest rates on record, many wealthy individuals who would ordinarily pay cash for real estate are filling out loan applications. The strategy? If they can earn a return on an investment with their money that’s higher than the rate they are paying their mortgage lender, then they come out on top. That was apparently Mark Zuckerberg’s thought when he recently refinanced his Palo Alto, California mansion.
Some wealthy individuals who might otherwise choose to pay cash for a home opt for a mortgage in a volatile real estate market. If you pay cash for a home and its value then plummets, you’re investment is diminished. Therefore, in an unstable market, some people aren’t willing to take the risk of paying cash. If you have a mortgage, however, theoretically you share the risk with the lender, who also has a vested interest in the value of the property.
Homeowners who have mortgage loans are also currently entitled to a tax deduction on interest paid. Therefore, for those with steady incomes, the deduction on mortgage interest can reduce the amount paid to Uncle Sam. Not so for people who pay cash.
What’s Right for You?
Sometimes the answer to whether you should get a mortgage or pay cash for a house isn’t clear. In assessing your own situation, among the other circumstances affecting your life and your financial situation, consider these factors:
Age: Mortgage lenders might consider older folks with sizeable savings but no income to be greater credit risks. After all, if your life expectancy won’t take you through the term of your loan, it’s no surprise banks might think twice about loaning you money. On the other hand, if you are in the prime of your life and have promising earning potential, the odds are much better for you to qualify for a loan.
Income: If you have a steady income, chances are that you’ll be able to make mortgage payments for an extended period of time. However, if your money comes from inheritance or retirement savings and you don’t have a steady income, then the prospect of having an adequate supply of money for 360 payments on a 30-year mortgage might not be as clear.
Family: If you are a bachelor or bachelorette with no plans for children, the decision to make a large upfront investment to buy a home may be pretty simple. If, however, you have dependents, that decision becomes more complicated. Have you saved adequately for private school tuition? For braces? For the first car? For college? If not, then tying a large amount of money up in a house may not be a wise decision.
Wealth: If your investment towards all-cash home purchase will wipe out your savings, it may not be a wise move. Depending on your circumstances, it could leave you at risk if you end up needing fast cash down the road for an emergency or unexpected situation. In fact, financial experts recommend that we should always have readily available funds to cover at least six months’ worth of living expenses. In contrast, if buying a house without a mortgage will still leave you financially comfortable, it might make more sense for you.
If you’re deciding whether to obtain a mortgage loan or pay cash for an upcoming house purchase, chances are you’re in pretty good shape financially. However, taking these ideas into consideration will help you make the right decision based on your unique circumstances and position in life.
Kenneth McCall loves to hike and ski. When he’s not busy with outdoor activities he is a managing partner at storage.com. Ken designs systems and tools for homeowners and businesses that need storage units throughout the country.