by Craig Rowland 8 October, 2013

A question came up on the forum about whether its best to buy a house with cash or with a mortgage. Here are my thoughts on the topic.

First, understand that homes are not investments as commonly portrayed. They are consumption items. You need someplace to live. If you want to have the place be your own that you customize to your liking, then owning is a good option. But rarely is buying a home as an investment a good idea. Consider:

1) When you are living in your home you cant easily realize the profits without home equity loans. Unlike stocks, bonds, cash, gold, etc. real estate is a very illiquid investment. Not just this, but what you think its worth and what its actually worth are two vastly different things. You cant find out a realistic price on your particular home until bids come in.

2) Homes require a lot of upkeep in terms of maintenance, home owners association fees, taxes, utilities, insurance, etc. A house is really expensive even outside a mortgage. Think of a house as a mutual fund with an extremely high annual expense ratio. Off the top of my head, a typical home could cost 2-3% of the actual value each year just in related expenses. So a $300,000 home could easily cost $6,000-10,000 a year in all expenses just to keep it (taxes, maintenance over time, etc.). Some areas could be much more than this.

3) If you decide to sell your house to capture your profits and stay in the local area, most of the local property has appreciated at the same rate as your own home! So any gains you made will be absorbed in others appreciated selling prices when you move local. The only way to really profit from a house is be lucky enough to buy one in an up and coming area, live there for years, and then move far away to a much cheaper area or local living situation. Then of course there are the real estate commissions, title fees, etc. to pay on any sale.

So with that out-of-the-way, lets talk mortgages and cash.

Paying for a house with cash or mortgage is much more of a psychological question than financial. Because we dont know future returns we cant say with any certainty at what rate a mortgage does or does not make sense except in the more extreme high/low ranges. For instance, if you can swing a 30 year mortgage for 1% a year Id say go for it. But if the mortgage is 20% a year, then perhaps its best to wait things out a bit, right?

Usually though mortgages fall in the mid-single digits in the U.S. This gets a little trickier to assess if its a good or bad idea. Many times the thinking is like this: I could earn 9% a year on my investments, so a 5% a year mortgage is a good deal and Ill hold a mortgage.

Yet, the reality is we dont know that will really happen. You could earn a lot less than 9% due a variety of issues. Maybe the market gives 9% a year for the next 30 years (or maybe not!). However, perhaps you are only invested in it for 10 years because you make bad investment decisions and lose a lot of money, etc. The  future is always full of surprises. And a future over 30 years of a mortgage is a really long time for surprises to happen.

The main question then is whether you like carrying large debt over your head. Some people dont like debt and dont want a mortgage. Others think it is OK depending.

So which is it? Pay cash or get a mortgage? I will leave you with some thoughts:

1) For the most part, Ive never come across anyone yet that paid off their mortgage and really regretted it. Sure you get some of the woulda, coulda, shoulda complaints about some fabulous investment returns they could have had if they hadnt paid off the mortgage. But this is usually hindsight analysis and they likely are forgetting the really bad investments they avoided with that same money. However, I have come across people who could have paid off their mortgage but instead invested the money and did regret it (due to investment losses). They still had a mortgage and no extra savings. Worst of both worlds.

2) If you put all your money into your house, and have no other reserves, you will be what is called House rich and cash poor. That means if you need money for an emergency it will all be in your house. The traditional narrative is: Just get a home equity loan if you need money. Yet, in an emergency (job loss, medical bills, lawsuits, etc.) that is the exact time no lender will touch you for a loan! Think about it. Banks are sunshine lenders. They dont go handing out money to desperate people likely to default. So if you are going to pay cash, make darn well sure you have a good amount of living expenses set aside just in case of a problem.

3) Consider hybrid approaches. Instead of putting all cash into a house immediately, you can make a very large down payment. Or you can make an extra payments a year which really throws off the compound interest the banks receive over the life of the loan. If you decide later that you want to pay off the mortgage in full, then do it. Just make sure there are no penalties in your agreement for early payment.

4) Lastly, I find mortgages tend to push people into bigger homes than they could really afford without it. Paying in cash can eliminate buying too much house which over the long-term can save you a lot of money in interest payments.

Whats my take? I think avoiding debt is a good idea. If you have the cash for the house, and a good living expense buffer. then pay off the house assuming all other debts with higher interest rates (like credit cards, auto loans, school loans, etc.) are paid off first.