Pros and cons of paying cash for a home
Considering paying cash for your dream home? So are more and more people.
The number of all-cash deals has risen 25 percent from a year ago, making up 30 percent of May 2011 home sales, according to the National Association of Realtors. These all-cash buyers are typically either trading down for retirement, investors or wealthy folks.
All-cash deals aren't for everyone
The key to deciding whether an all-cash home purchase is for you, is to weigh the pros and cons. Also, you should view your mortgage as an investment like any other with liquidity, risk and return. These days, the pros of an all-cash purchase are quite compelling: stronger negotiating power, waving goodbye to monthly payments and bypassing the lengthy, maddening mortgage-approval process.
However, certain drawbacks also exist, including forgoing mortgage interest deductions, depleting savings and losing out on future--perhaps more profitable--investment opportunities. "Generally, it makes more sense to invest that mortgage money rather than paying cash," says Bob Williams, a financial advisor at Delta Trust Investments in Little Rock, Arkansas.
For starters, nail down your finances first, though. Six months of savings, a healthy stock portfolio and retirement account funding--especially 401ks--are the baseline, say experts.
That said, here's a rundown of the pros and cons.
- Stronger negotiating power. Yes, it's still a buyer's market, but you can negotiate even better deals by paying cash, says Eric Tyson, the co-author of Mortgages for Dummies. Nabbing a house for 5 percent less than the market value is not uncommon. Also, you won't lose out to a growing army of investors who are plunking down cash for attractive properties.
Lastly, you'll have more leverage when selling your home. Why? Without a mortgage, you can carry the next buyer's mortgage and speed along the sale.
- No monthly payments. You shouldn't underestimate the comfort level of owning your own home--especially as foreclosures mount up. "You can sleep better at night," says Williams, "and people don't understand these psychological benefits."
Consider other more tangible benefits too, such as foregoing title insurance or private mortgage insurance.
- By passing the grueling mortgage-approval processes. Credit score requirements for getting a mortgage these days average 760, compared to 720 just a few years ago. If your scores are low, you can still buy a home with cash and without fear of rejection. According to the Federal Reserve, 25 percent of mortgage applicants are turned down.
In addition to higher credit score and down payment requirements, loads more paperwork is required from borrowers these days, including income documentation, asset statements, tax returns, and more. Most sellers are concerned that potential homeowners can't finance a mortgage, says Tyson.
- Losing out on the mortgage interest deduction. This deduction is one of the few remaining, says Williams. Those who can best benefit are in at least the 28 percent tax bracket, he adds.
And this deduction adds up. Let's say you're in the 28 percent tax bracket and have a 4.5 percent mortgage rate. After taking your deduction, the effective rate drops to 3.24 percent. That's the benchmark to shoot for when scouting out other investments, he adds.
- Lost investment opportunity. With mortgage rates at 4.59 percent for a 30-year mortgage, borrowing is still dirt-cheap. And paying cash for a home ties up that money. Over time, home sale price returns are paltry too--averaging only 5.4 percent between 1968 and 2010, according to the NAR.
The upshot: much better options exist. Stock market returns usually outperform other investments. And even some bonds make sense. For example, a Tennessee Valley Authority bond rated AAA yields 4.62 percent and comes due in 2039. And a 30-year Treasury bond yields over 4 percent.
"Or what about other attractive investment opportunities," says Tyson, "like investing in a small business?"
- Depleting your savings. It takes years to replenish savings at low interest rates. And tying up all your money in a home also reduces your overall liquidity.
For example, say you pay cash for a home and begin replenishing your savings account at $1,000 per month at a 4.6 percent interest rate. It will take you 17 to 20 years to recoup your all-cash payment. "You can save faster, but there's more risk," says Williams.
- Homes are fairly illiquid investments. These days, it takes 9.3 months to sell a home versus the usual six months, according to RealtyTrac. Conversely, most other investments like bonds or stocks are easily sold on an exchange.
What happens if you pay cash and later need the money? You can always get a home equity loan or reverse mortgage, counsels Williams.
Constance Gustke is a New York-based journalist who writes about business topics. She was a Fortune reporter, Forbes.com contributor and Worth features editor. Gustke is also a regular contributor to CNBC.