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