Why It's a Mistake to Put More Than 20% Down on a Home

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For many families across the country, the concept of buying their next home with cash may sound like a fantasy. Yet according to RealtyTrac, the nation's leading source for housing data, nearly 40 percent of all U.S. homes purchased in the second quarter of 2014 were cash deals.

In Orange County, California, where I live, there were 7,500 all-cash purchases in 2012 and 2013, and only 10 percent of those subsequently refinanced the property. But while the buyers' initial reactions to making buying a home without taking on any debt may be to celebrate your fiscal responsibility and fist-bump your poker buddies, these buyers may not actually be so financially smart. Using your cash in this fashion may cost you money in the long run.

Here are three things to consider before bringing a full price cashier's check to the escrow office at closing:

1. Home Mortgage Interest Deduction

The first benefit of financing your home purchase is the home mortgage interest deduction offered by the Internal Revenue Service. A homeowner is allowed to deduct the interest paid on his or her first and second homes (up to $1 million of debt), which means a tax savings. For example, a buyer with a $300,000 loan will realize a tax savings of nearly $4,000 in the first year of the loan, when compared to the all-cash buyer. The tax savings can be considered a subsidy from Uncle Sam, which lowers the effective interest rate on your loan.

In the above example, if the borrower had a 30-year fixed rate loan at 4.25 percent and pays an effective income tax rate of 25 percent, the after-tax rate on the loan becomes less than 3 percent. If you shorten the loan term to 15 years at a rate of 3.5 percent, you can lower the effective interest rate to less than 2.5 percent. The opportunity to borrow money at these rates is hard to pass up.

If you are a high-income earner, watch out. Up to 80 percent of your deductions could be phased out based on your earnings.

2. Real Estate Leverage

The next benefit of financing your real estate purchase is that it gives you the power of leverage. As the owner of real estate, you are entitled to the full market value fluctuation whether you paid all cash or borrowed 90 percent of the purchase price.

For example, let's say you paid all cash for a $300,000 home, and it appreciates 2 percent in a year. Your return on the cash you invested is 2 percent ($6,000 divided by $300,000). Now let's say your neighbor bought the same model house for the same price but only made a 20 percent down payment ($60,000). Your neighbor realizes the same $6,000 in appreciation but only invested $80,588 (the $60,000 down payment plus 12 monthly payments of $1,716), generating a return of 7.44 percent on the cash invested in the first year -- compared to your 2 percent return.

Using this leverage is one of the great benefits of buying real estate that is unmatched in other areas of investing. Imagine if you were allowed to buy stock with only 20 percent down -- but were allowed to keep all of the appreciation.

3. Best Return on Money?

Before making a decision to use all cash for a real estate purchase, you should also evaluate the return you could earn from other uses of the cash. Based on the example above where the cost of borrowing money is only 2.5 percent, the borrower should look for alternative investment options that would earn more than 2.5 percent. If the alternative investment produces a net return greater than 2.5 percent, the buyer is better off borrowing money to purchase the house and investing the cash.

Being in a position to purchase your home with cash is certainly an achievement worth celebrating, but it may not be the best financial decision to continue building wealth. "Engaging your loan officer before you start looking for a property can save you time and eliminate a lot of the stress in the home buying process," says Jeff Beckman, a loan consultant with the Kappel Mortgage Group in Sacramento, California.

Consider the impact of the home mortgage interest deduction, the ability to leverage a real estate asset and the alternative investment options for your cash before deciding how much cash to put toward your home purchase. Include an experienced financial adviser in your decision-making process to examine all of the implications to your personal financial situation.

Robert Pagliarini is a best-selling author and Mission Viejo financial planner who focuses on sudden wealth recipients. Connect with him on Twitter at @rpagliarini.

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Why It's a Mistake to Put More Than 20% Down on a Home
In 2013, the median lot size of a new sold single-family house was 8,596 square feet, or just under 0.2 acres. While that might not seem like a lot for you suburban homeowners, a regional breakdown shows that the small average size isn't due to urban inhabitants alone. The Northeast enjoys the largest average lot, at 13,052 square feet, while the less densely populated South and West lay claim to just 8,649 square feet and 6,796 square feet, respectively.
From a footprint of 1,650 square feet in 1978, the average American home has grown 50 percent, to 2,478 square feet. Yet tough times seem to be squeezing our expansionary attitude. Although new single-family homes sold in 2013 clocked in at a median 2,478 square feet, single-family homes completed in 2013 amounted to just 2,384 square feet. Homebuilder confidence has plummeted into pessimism in the last few months, hinting that the housing market's road to recovery might be rougher than expected.

While birth rates have held relatively steady for the past 40 years, everyone apparently needs more elbow room. The share of homes with four or more bedrooms has jumped from 27 percent in 1978 to 51 percent in 2013. And where would a bedroom be without a bathroom? While just 8 percent of 1978 homes had three or more baths, 37 percent of homes now fall in that category.

From 2008 to 2013, both the share of homes with four or more bedrooms and the share of homes with three or more bathrooms have jumped 10 percentage points, while median square footage is up 10.9 percent for the same period.
 

If there's one strong sign of new housing demand, it's home prices. After nose-diving during the Great Recession to a median sales price of just $216,700, home prices have been roaring back up. In 2013, the median sales price for a new single-family home was $268,900. But for those on the housing hunt, don't be discouraged. Home prices today still don't hold a candle to costs in 2006, according to the well-regarded Case-Shiller Home Price Index. In 2006, the index topped 200 before plummeting to less than 140, and current rates put the index just above 170.
It is America, after all. Our industrialized nation was built on the back of Henry Ford, and America is in no danger of breaking its automobile addiction. In 2013, a whopping 300,000 of the 429,000 new single-family homes sold included a two-car garage. And 98,000 new homes included a three-car garage -- the highest amount since 2007. Of all new homes built, only 10,000 failed to include a garage or carport.
American homebuyers are building bigger homes than ever before. But if there's one thing the recent recession has shown us, bigger isn't always better. Although 30 percent of Americans believe real estate is the best long-term investment, homeownership isn't for everyone. There are plenty of reasons to spend less or invest elsewhere -- and leave keeping up with the Joneses to Mr. and Mrs. Smith.
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