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March 6, 2000
"My wife and I are both in
our late 20s and would like to buy a home for $250,000. We have $500,000 in
available assets, including cash, stock, and bonds, as well as $100,000 in
retirement assets. We have no debt. We can afford to pay cash for the home.
Should we? What should we consider in making that decision?"
An all-cash purchase should be
viewed as an investment. The investment is not the house, because you are buying
the house, and will enjoy any appreciation in its value, whether you pay all
cash or take out a mortgage. The investment in an all-cash transaction is the
mortgage you avoid.
Suppose, for example, the
alternative to an all-cash transaction is a $200,000 mortgage at 8.5% with no
additional costs. If you pay the $200,000 in cash instead, your return on that
cash is the 8.5% that you would have paid on the mortgage.
This might be called a
"no-mortgage" investment.
In considering whether investment
in the no-mortgage is wise, you compare it to your other investments with
respect to three things: return, risk and liquidity. The no-mortgage has a
return of about 8.5%, it is risk-free, and it provides some but not high
liquidity. Since your home would have no liens on it, you could easily obtain
cash in a few days with a home equity loan.
Compare this investment to your
other assets. Your cash assets carry a lower return, probably have very low
risk, but offer the highest liquidity. You want some of your assets in this
form, but not more than you need for every day use and for emergencies.
Your bonds may have a higher or
lower return, depending on their risk category. Adjusted for risk, however, they
are an inferior investment to the no-mortgage. Only US Government bonds are risk
free, and they yield 1-2% less than the no-mortgage. Furthermore, bonds are not
very liquid in the small amounts you would sell. I prefer the no-mortgage over
bonds.
Stocks in contrast generally earn a
higher return than the no-mortgage, but they also carry the risk of price
fluctuations. You are young and can afford to have stocks comprise a significant
portion of your portfolio. But also because you are young, you have no
experience with protracted declines in the stock market, and might be inclined
to overdo it.
If I had your portfolio and was
your age, I think I would hold about $50,000 in cash assets, $200,000 in a
diversified portfolio of common stock, and a mortgage-free house. But that's a
"conservative" portfolio, and no doubt it is influenced by the fact
that I am not in fact your age.
December 18, 2000
"In
a recent article, you said that paying all cash for a house made sense if the
investment return on the cash was lower than the mortgage rate.
But my numbers show otherwise. I am currently earning 5.5% on 200K
invested in a money market fund, and the mortgage offered me has a rate of
7.75%. If I pay cash for the
house, I save $315,818 in mortgage interest over 30 years. But if I take the
mortgage and invest the 200K at 5.5%, after 30 years I have $1, 037, 478. Is
there something wrong with my logic?�
Yes.
Comparing interest payments in one case with future wealth in another is
comparing apples and oranges. You
should compare future wealth in one case with future wealth in another.
Furthermore,
you�re forgetting that if you take the mortgage, you must make monthly
mortgage payments to the lender of $1432.83, whereas if you pay cash, you don�t
make these payments.
Your
calculation that you would have $1,037,478 after 30 years if you take the
mortgage and invest the 200K at 5.5% is correct.
Your wealth in the all-cash transaction is the value of $1432.83 invested
every month in the money market fund. This
turns out to be $1,309,051. You
will have more wealth if you pay cash, which is consistent with the principle
that paying cash is preferable if the return on investment is below the mortgage
rate.
But
this example reveals an important proviso:
to be better off in the future from paying cash, you must invest the
same monthly payment that you would have made if you had borrowed.
If the $1432.83 you pay the lender in the mortgage case is spent in the
all-cash case, you will end up substantially poorer paying all-cash.
Copyright
Jack Guttentag 2002
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