All-cash offers on homes are all the rage lately, but is it as good an idea as most of us think? While they make for an attractive offer to the seller, you’ll want to consider the consequences of tying up your money into a fixed asset like a home, as you could make more money long-term by taking on a mortgage and plowing some of that money into an investment fund.
Why cash isn’t always king in real estate
It seems so simple at first: If you buy a house outright with cash, then you don’t have to bother going into debt by taking on a mortgage. After all, you’d avoid paying $129,444 in interest alone, for a $250,000 mortgage that charges 3% interest spread out over 30 years. Who wants to do that?
Well, the problem is opportunity cost: If you were to put most of that cash into an investment fund, the rate of return would outpace the extra money you’d pay on interest, especially since mortgage rates are so low. Over the past 30 years, the S&P 500 index has delivered a compound average annual growth rate of 10.7% per year, while mortgage interest rates are much lower. The average 30-year fixed-rate mortgage is currently 2.84%, and the average rate for the 15-year fixed-rate mortgage is 2.24%. Investopedia has a great example of how this works:
Suppose you bought a $300,000 home that has since risen in value by $100,000 and is now worth $400,000. If you had paid cash for the home, your return would be 33% (a $100,000 gain on your $300,000). However, if you had put 20% down and borrowed the remaining 80%, your return would be 166% (a $100,000 gain on your $60,000 down payment). This oversimplified example ignores mortgage payments, tax deductions, and other factors, but that’s a general principle.
And by splitting that cash up, you’d be able to take advantage of two types of investments, rather than just one. That means you could have an index fund that has an annualized return of 10%, in addition to your property, which has an average annual rate of return that can range from 5-15%. When you look at it that way, paying, say, 3% on a mortgage isn’t as big of a deal. This is why wealthy people often take out a mortgage strategically for the leverage, even though they could pay off the loan at any time.
Of course, caveats apply. Investing in property and stocks both carry a certain amount of risk, as past performance does not guarantee future results. And everyone’s financial situation is different, too. One of the advantages of owning a property without financing is that you won’t have to deal with monthly mortgage payments straining your budget. Plus, sometimes you just simply need a home, and in this seller’s market sometimes cash really is, in fact, king.
Consider consulting with a financial advisor before any major investment, including an all-cash purchase of a home. A home is a great asset, but it’s not easy to convert back into cash when you need it, and you might make better use of some of that cash in other investments.