Why would a person want a mortgage if they didn't need it?
January 6, 2012 12:31 PM   Subscribe

Assuming that you could buy a house outright, for cash, why would you get a mortgage? A conversation got me researching this recently. Many articles suggest that if the interest rate is low, a mortgage is better. Yet I can't for the life of me figure out why paying low interest is better than paying no interest. A person with a 30-year mortgage usually ends up paying about 2 times the principal. School me, financial mefites. FYI: this is just a curiosity. I'm in no position to actually do this in reality.
posted by the jam to Work & Money (44 answers total) 28 users marked this as a favorite
Income tax deductions would be a huge one. As a general rule it ends up being more than the standard deduction and can save you quite a bit on your taxes.
posted by lyra4 at 12:35 PM on January 6, 2012 [3 favorites]

You can often deduct mortgage interest of state and federal taxes. Combine this with a situation where you can get interest on that cash payment and a mortgage may be attractive. In other words, if you have $200,000 in cash, it's not that you take out the mortgage and spend that cash on fast cars and fabrege eggs. You take that money and invest it in, say, the stock market, using your earnings to pay off the mortgage and hopefully have a little left over as profit.

I'm not going to run the numbers but I think the situations in which this is feasible are pretty slim.
posted by muddgirl at 12:36 PM on January 6, 2012 [2 favorites]

If I can get a mortgage at 3.5% for $500,000 right now and I think I can invest $500,000 and get a rate of return of anything higher than 3.5% (or a bit higher, with closing costs/fees/etc), then it would make more sense to do the mortgage and invest the rest.
posted by Grither at 12:36 PM on January 6, 2012 [3 favorites]

First, you get a tax deduction for the mortgage interest.

Second, you may be able to earn a greater return on your money by investing it elsewhere. If the rate of return on your investment is greater than the interest on the mortgage, you're much better off.
posted by mikeand1 at 12:37 PM on January 6, 2012 [2 favorites]

A simple answer is because money can earn more money through various means (the simplest is just a high-yield savings account, of course, and there are ways to earn more money with your money via interest or investment, some safer than others), and if instead of keeping your money to invest it, you use it to buy something, you don't have it anymore. Theoretically the money you earn on your money could be more than the money you lose on interest.

But that's rarely the case alone, and there's also other things that make a mortgage make sense -- mortgage interest deductions on your taxes are on a big one, and I'm sure others will mention others.
posted by brainmouse at 12:37 PM on January 6, 2012

The very short answer is that if you got a mortgage, the cash you would have used to buy the house isn't just going to be sitting there, you'd invest it and make money with it. So if you can get a mortgage for a fixed rate of 3.5% but you can get a CD or money market account or mutual fund that will net you 5%, you're clearing 1.5% on taking out the mortgage and putting your money to better use.

Of course, you'd rarely be able to get a money market account or CD or other safe investment that paid a rate above what 30-year-fixed mortgages are costing, so in reality it's a bit more complicated. But that's the gist of it.
posted by iminurmefi at 12:37 PM on January 6, 2012

A friend of mine is a loan officer at a TOO BIG BANK in a VERY EXPENSIVE CITY. He gets a lot of "jumbo" mortgages from people who could, ostensibly, buy multi-million dollar properties outright, but choose to take out a mortgage because 1) the mortgage interest deduction nullifies most (if not all) of the interest they're paying and/or 2) they can earn a high enough return with cash on hand to offset any interest paid.
posted by Oktober at 12:37 PM on January 6, 2012 [2 favorites]

You're also reducing your risk by taking a mortgage in a non-recourse state. Look at all the people who walked away from their houses when home values dropped. They didn't take the loss; the bank did.
posted by mikeand1 at 12:40 PM on January 6, 2012 [6 favorites]

If I can buy a 100k house cash, perhaps I can buy a 200k house with a mortgage. Say I put my 100k down, I borrow 100k and end up paying back 200k over the lifetime of the mortgage. The house appreciates a lot over the 25 years of the mortgage so I sell it for 800k. I buy a small 300k house and I have 500k left over to spend on ski holidays in my retirement.

This could easily be more than I would have made by buying the smaller house in the first place and just investing my money - plus I get to live in a bigger house in the meantime.
posted by emilyw at 12:43 PM on January 6, 2012 [1 favorite]

Tax deduction is one but also opportunity cost, inflation, and diversification.

With opportunity cost, let's say:
Mortgage, you have to pay 1%
Saving Account, you'll get 1.5%

Then you're actually earning an extra 0.5% (1.5%-1%) on your money if you get a mortgage and invest rest of the money.

Now let's say inflation is at 2%
You're now getting paid to have a mortgage, your interest rate of 1% - 2% = -1%. See this article.

Of course, you are also losing money if you did invest your money in a 1.5% account.

Lastly for diversification - for most people, their house is their biggest assets, which means they're putting most of their eggs in one basket. By having a mortgage, they can have their wealth tied into other modes of saving (cash, stocks, bonds, or other properties).
posted by vocpanda at 12:49 PM on January 6, 2012 [1 favorite]

Just to follow up on mikeand1's comment people take out a mortgage in many situations so that they don't bear all the risk of loss associated with the property in unforeseen situations.
posted by mercredi at 12:54 PM on January 6, 2012 [2 favorites]

First, you get a tax deduction for the mortgage interest.

how does this help? It just reduces the effective mortgage rate, doesn't it? You still have to spend the money in order to get the tax deduction, so you're not actually gaining anything - you're just losing slightly less.
posted by Mars Saxman at 12:56 PM on January 6, 2012 [2 favorites]

Many articles suggest that if the interest rate is low, a mortgage is better. Yet I can't for the life of me figure out why paying low interest is better than paying no interest.

Because the money used to buy the house could be used for other things, like saving for retirement and investing.

If the stock market returns 6% over 30 years, and the mortgage interest rate is 3.5%, then you do better paying off the mortgage at a low interest rate and investing the money.

That said, everyone who used this strategy in the late 1990s was kicking themselves.

It works in reverse, too: instead of paying off your mortgage, you want your extra money to go towards savings for retirement, paying off other, higher-interest, non-deductible-interest loans, and savings for large purchases that you would otherwise have to finance before you pay down your mortgage.
First, you get a tax deduction for the mortgage interest.

how does this help? It just reduces the effective mortgage rate, doesn't it?
It might make sense if the money you keep by not paying off the mortgage goes to buy something that you would otherwise finance (eg, a car or college tuition), because the mortgage interest is deductible while the interest on a car loan or college loan isn't.
posted by deanc at 12:59 PM on January 6, 2012

Mars Saxman - it's all about opportunity cost. If the mortgage interest rate is 5% and you can get 4.5% in a bond or something, with the deduction for mortgage interest your effective interest rate is less than what you can make in the bond. The difference between what you're earning with the cash and what you're spending on the mortgage is 'profit.'

The trick is that it takes money to earn money. Big banks and investment firms borrow money to make money all the time. There is always a risk that you will lose money on the deal.
posted by muddgirl at 1:00 PM on January 6, 2012

Mortgage interest deductions are directly offset by taxes on whatever gains you get with the cash you don't have tied up in your house. It's a mystery to me why anyone would consider giving money to a bank to get a deduction when they could give it to a charity.

It may make financial mathematical sense in a lot of cases because of convoluted tax laws regarding differences in long and short term capital gains, but the math that people use doesn't account for the fact that the grass on your lawn is greener and feels better on your feet when it is paid for.

You can leverage your cash and borrow money on a property and send that to get more property etc etc and its how a lot of people get rich. Leverage is how most people get unrich, too.
posted by bensherman at 1:07 PM on January 6, 2012 [1 favorite]

With the scenario given, deducting home mortgage interest alone is an awful reason to take the mortgage rather than pay cash. The deduction only reduces the effective interest rate that you pay. Each dollar you pay in interest does not even reduce your tax liability by a dollar--it only reduces your tax liability by the amount of your marginal income tax rate.

The interest deduction does affect the opportunity cost calculations, because it reduces the effective interest rate of the mortgage. That makes it harder to find an alternative investment that pays a higher return.
posted by massysett at 1:07 PM on January 6, 2012 [4 favorites]

The purpose of mortgages, on a societal level, is to make housing more expensive.

If you could pay for a house outright then absolutely, you should do so.
posted by tel3path at 1:12 PM on January 6, 2012 [2 favorites]

There is also the factor that property taxes and homeowner's insurance are automatically part of your payment, which is very convenient, especially if you are not used to dealing with this stuff separately. After our house was paid off, it was an adjustment to have to come up with a chunk of money for property tax annually.
posted by Danf at 1:12 PM on January 6, 2012

...that is, assuming you want the house to live in.

If you want to do fancy investment footwork, some of the above answers may explicate the advantages of doing so.
posted by tel3path at 1:14 PM on January 6, 2012

Aside from the obvious financial reasoning people have already pointed out, there are borrowers that do it for what I'd describe as "relationship" reasons. For example, a bank like Silicon Valley Bank writes big mortgages to high-net-worth VC types who have more cash in low/no-interest accounts than the amount of their mortgage. Borrowers do this to garner favor with the bankers, which pays off in terms of future business deals and access to corporate loans. And sometimes rich people just like having a "banker" at their beck and call.
posted by mullacc at 1:16 PM on January 6, 2012

With the scenario given, deducting home mortgage interest alone is an awful reason to take the mortgage rather than pay cash.

I don't think anyone said that it was a good reason on its own.
posted by muddgirl at 1:17 PM on January 6, 2012

First, you get a tax deduction for the mortgage interest.

how does this help? It just reduces the effective mortgage rate, doesn't it?

Bingo! A tax deduction on an expense reduces the size of the expense, but it's still an expense. Say you borrow $100,000 at 3% for fifteen years. You're going to pay $24k in interest if you take the whole fifteen years to pay that off. Now even assuming you're entitled to the full mortgage interest deduction, it's a deduction against your AGI, not against your tax liability. So it effectively reduces your income, which is only being taxed at 25% (or whatever). So your income over that period is reduced by $24,000, reducing your tax liability by $6,000, for an effective total interest payment of $18,000. In short, because you got the mortgage, even with the tax deduction you're out $18,000 you'd have kept if you'd just paid cash.

Rule of thumb: don't go out of your way to get tax deductions. If it's something you were going to spend money on anyway, hey, awesome. You can now afford a little more than you could before, or you can just pocket the savings. If it's not something you were necessarily going to do, the deduction means that it'll cost you less money, but it won't actually put any money in your pocket.

That being said, the interest cost may be worth it. The obvious reason is if you can find an investment that will pay you more than 3%. These days, good luck with that, but if you can do it, you wind up making the difference between your return and the 3% you're paying to borrow the money. Awesome.

The other reason is that liquidity is a good thing. If you buy a house cash, you've got a lot of money tied up in the house that you can't spend on other things. Like cars, your kids' educations, stuff like that. You can maybe afford to buy the house cash, but can you afford to do that and pay for all the other things you need to pay for? If not, then 3% is a small price to pay for being able to take care of those expenses without having to borrow money at a higher rate or simply do without. If so, then borrowing the money makes no sense unless you've got a great investment vehicle going.
posted by valkyryn at 1:18 PM on January 6, 2012 [6 favorites]

You don't have to find an investment better than 3% over 15 years - you pay $18,000 in interest to reduce your tax liability by $6,000, so you only need to find an investment better than 1.5% over 15 years (back of the envelope).
posted by muddgirl at 1:21 PM on January 6, 2012

OK maybe like 2%.
posted by muddgirl at 1:25 PM on January 6, 2012

Average return on the stock market since it's been open is almost 10%. Obviously you can't base your own returns on 10%, but for the next 30 years, I would be very surprised if you couldn't beat 3.91% by a significant amount, making the mortgage over paying cash make sense, even without the tax deductions.
posted by Grither at 1:29 PM on January 6, 2012

Of course, I'm an optimist, and I don't think the world economy is going to completely collapse in the next 30 years (and of course, even if it does completely collapse, it won't really matter if you paid in cash or with a mortgage, we'll still all be fucked).
posted by Grither at 1:30 PM on January 6, 2012

I want to reemphasize the importance of keeping cash liquid. It's one thing if you save up $200,000 exclusively for a house, another if you save up $200,000 in order to use it as a nest egg, or for emergencies, or to live more comfortably. Once the money's all poured into a house, you may be real estate rich, but cash poor. Similar to playing Monopoly, there are pitfalls to being cash poor.
posted by jabberjaw at 1:35 PM on January 6, 2012 [6 favorites]

Here's a slam-dunk in my book:

30-year Muni Bond (tax-exempt interest income) is at 3.7% right now.

30-year Fixed Mortgage is at 3.9%, and the interest is tax-deductible, so your effective rate is even below the 3.7%.

So right off the bat, you'll be out-earning the interest you're paying with your investment. And, while a little illiquid, a Muni Bond is certainly more liquid than, say, a house. So if push comes to shove and you need all your cash fast, you still have it available at a moment's notice.

So have someone else pay for your interest (and then some), keep your house, and keep your cash? That's a winner. Unless someone here can tell me that I'm just 180 degrees wrong.
posted by trubleu1212 at 1:39 PM on January 6, 2012 [1 favorite]

Two things:

1 - A person with a 30-year mortgage usually ends up paying about 2 times the principal.

Not anymore. Precisely because interest rates are so low, the average 30-year mortgage no longer ends up costing you 2 times the principal. At 4%, where things are right now, you'd pay 1.72 times the principal over time. If the 30-year rate goes down to 3%, you'd pay 1.52 times the principal. It's still money, but it's a lot less than what conventional wisdom used to say you'd pay with a 30-year mortgage.

2 - you shouldn't compare the current interest rate on a 30-year mortgage to just the investments you could make today; you should also compare it to the investments you could make 5, 10, 15, 20, and 25 years from now. If you believe that interest rates on (what you consider) relatively "safe" investments - say, government bonds - will be over 3-4% sometime in the next 30 years, it will be better to have that money available when those interest rates go up than to have it tied up in a house, even if you can't make those investments today. Because when those rates go up, you won't be able to get a 3-4% mortgage for the house you paid cash for.
posted by mistersix at 1:39 PM on January 6, 2012 [1 favorite]

Average return on the stock market since it's been open is almost 10%.

Great, Grither. I assume I can borrow your time machine to go back and invest in .. 1792? ;)

The point I really want to make is that the answer to this question does have some temporal variability. You want to invest in a rising market (which, to be fair, has been most of the time) but now? Might be great. Might not. Need to polish my crystal ball some.
posted by zomg at 1:40 PM on January 6, 2012 [1 favorite]

If you spend all your cash on a house, the asset is illiquid. The value of the house may depreciate and it costs money and time to sell and recoup the cash. Job loss, serious illness, more attractive investment opportunity, great lifetime opportunity, or simply other stuff - the unknown can occur and it can be good to have some liquidity available. Even with insurance, a prolonged job loss, a serious illness and a difficult insurance company, a friend invents Snuggies or Chia pets and wants you to invest, a rare chance to study butterflies in Bora Bora can occur. Many of these are unlikely but life is made up of unlikely happenings. Liquidity gives you options and flexibility. I'd opt for a large down payment instead of total cash
posted by shoesietart at 2:16 PM on January 6, 2012

You don't have to find an investment better than 3% over 15 years - you pay $18,000 in interest to reduce your tax liability by $6,000, so you only need to find an investment better than 1.5% over 15 years (back of the envelope).

That presumes a 33% marginal tax rate which it is statistically unlikely you pay - 97% of the population has an adjusted gross income under 200,000.

Determining your true savings from the deduction requires looking at your annual income; in 2010 a single person making between 32k and 82.4k was paying 25% on that, so spending $1 in mortgage interest means avoiding $0.25 in tax. From 82.4k to 171.85k it was 28%, so a savings of $0.28 per $1 of interest.

The cash or loan question also begs for some discussion of middle ground. A mortgage is front-loaded with interest, so decreasing the loan amount makes for sizable savings over the lifetime of the loan. If someone had dropped the amount of our painful mortgage on our lap the day before our closing we'd probably have cut our loan in half but we'd still have borrowed some.

I don't see anyone mentioning it so one more thing is pertinent about the investing of that money - long-term capital gain taxes are notably lower than income. 10 to 13% lower at the moment for our hypothetical <2>
So if you take that $1 and earn 10% annually you'll earn $0.10, which you'll pay 15% on if you're our 50k/yr person - 1 and a half cents, while you will simultaneously avoid paying the 2.5 cents on the 10 cents in regular income that you offset in an interest deduction.
posted by phearlez at 2:19 PM on January 6, 2012 [1 favorite]

>the mortgage interest deduction nullifies most (if not all) of the interest they're paying

The inability of some people to understand basic economic concepts is amazing. If you pay $10,000 in mortgage interest, and if your marginal tax rate is 25%, then your corresponding 10K deduction will end up saving you $2,500. The net cost to you is still $7,500. That is far from "nullifying most or all of the interest paid."

You would nullify 80-100% of the interest only if you were paying taxes at a marginal rate of 80-100%, and you would not want that, would you?

The marginal rates for the highest earners before the Reagan administration were about 70%. Thankfully, those days are behind us.

But of course during that year you are not paying rent, which would very likely be over $10,000 itself for the same time period - without any tax deduction. That is where there is a major difference. But for the OP, who is asking about buying a house for cash vs. a mortgage, that is not a consideration.
posted by megatherium at 4:05 PM on January 6, 2012 [1 favorite]

Outside the USA there are generally no tax deductions for mortgages or home ownership, so it almost always makes sense to (kind of) buy outright if you can.


There are several other factors to consider anyway:

1. I have heard (but I don't know if it's true) that buying a house outright triggers a tax investigation in many countries. If you are at all concerned about the IRD examining your tax payment history, this would be something to avoid.

2. As others have said, your money is not as liquid if it is tied up in your house. When we bought recently, we got a larger than necessary mortgage for that reason, and put our savings in an offset account, where they are deducted against the principal of the mortgage before each interest calculation is made, so that we only pay interest on mortage minus savings, but the savings are still available for use in an emergency.

3. A common strategy here is to buy a house to live in and a small apartment as soon as possible afterwards as an investment property. We are not going to do this, but most people I know have. If you have enough to buy a house outright it MIGHT make sense to split that and buy two properties, especially as (here) an investment property attracts a lot of tax benefits (i.e. by making negative gearing possible).

(As far as I know, mortgage rates in Australia have NEVER been low enough that your savings could be earning more money elsewhere. At least, not in my lifetime. )
posted by lollusc at 5:09 PM on January 6, 2012 [3 favorites]

Thank goodness other folks besides me got to the mortgage interest thing first. Don't take out a huge loan just for the sake of paying a little less tax. If you can't run the numbers for yourself, find an impartial financial adviser (not your mortgage broker) who will do it for your specific situation and take it from there.
posted by Sublimity at 5:25 PM on January 6, 2012 [1 favorite]

Valkyrn has it.

Remember that the interest is still a cost, regardless of reductions through tax deductions. The real benefit to the long-term debt (mortgage) is that it keeps your money available for other investments. But you will always need to make more than the interest cost to come out ahead on a bottom-line basis.

This is why people do indeed buy houses for cash.
posted by yellowcandy at 6:13 PM on January 6, 2012 [1 favorite]

A home loan is usually the cheapest loan you can get. So if you get one that lets you pay it down early without penalty and then redraw, and you then pay most of it off super-quickly and leave just enough owing to keep it alive for the agreed term, you've effectively got yourself access to a very low-interest line of credit to deal with life's little emergencies. Which can be quite handy if you've just blown the major portion of your accumulated savings on acquiring a house.
posted by flabdablet at 5:28 AM on January 7, 2012

People seem to be forgetting a couple of things.
If you plan to stay only a few years in the house it makes perfect sense to get a mortgage and invest the cash elsewhere for all the reasons stated above. Plus your relatively small down payment will increase in value relative to the price of real estate. E.G. you spend $5,000 on a $100,000 house and later sell the house for 120,000 Your 5,000 has made you $20,000.

If you pay 100% and do not go with a mortgage the only way to realize any profit from your investment is to sell the house.
posted by Gungho at 6:32 AM on January 7, 2012

I own my house outright. I use the standard deduction, and file the short form for my US federal taxes. The tax deduction on my house might save me a small amount, but it's nice to have easier taxes. When you calculate the savings, you should include an offset for the difference between taxes using the standard deduction and the long form/itemizing.

If there's a financial crisis, I can get money out by borrowing against my equity. Many people borrowed against their homes to invest in the bull market. Some got out in time and made a bundle. Some lost a lot of money. There's lost opportunity cost; maybe I could invest cash profitably, but there's also transaction cost. A mortgage requires points and fees in addition to inspection and appraisal which I got anyway. It's an investment I can live in, so even if it loses value on paper, I'm still benefiting from it. Maybe it will appreciate in value; my last house appreciated 100% in 20 years. If I had gotten a mortgage 5 years ago when I bought, and invested the money, I'd probably have lost quite a bit of it when the market tanked.

Right now, it's not certain that housing will gain value at all, depending on your area. I don't enjoy investing, and I'm a pretty conservative investor, which is appropriate for my age. I'm 13 years from retirement, and not having a mortgage payment allows me save aggressively. My house is well-suited for retirement.

One concern is that if I were sued for something, my house could be seized, but that would be true of investments, too.
posted by theora55 at 9:39 AM on January 7, 2012 [1 favorite]

E.G. you spend $5,000 on a $100,000 house and later sell the house for 120,000 Your 5,000 has made you $20,000.

Um, this sounds nice but you have various other costs like mortgage servicing fees and PMI to consider if your down-payment is only 5%.

When the housing market was doing well, getting a big mortgage was indeed the best way to leverage up your investment for an average person, but we know how that all turned out once everybody jumped onto that.
posted by of strange foe at 2:08 PM on January 7, 2012

the 5 out of a hundred was just for the purposes of simple math. The concept is that you get ALL the equity when you sell the house, so in a rising market you tend to make boucou bucks on your down payment.
posted by Gungho at 5:22 PM on January 7, 2012

It can be difficult (not to mention more costly) to get homeowner's insurance without a mortgage.
posted by Ike_Arumba at 7:28 PM on January 7, 2012

Ike, that's just simply not the case.

Mortgage lenders require buyers to maintain homeowner's insurance, but insurance rates are not determined by mortgage debt in any way.
posted by yellowcandy at 7:40 PM on January 8, 2012

There are two ways that inflation can make a 30-year fixed mortgage a decent bet:

1) If there is across the board price inflation, the value of the house will rise.

2) If you take out a 30 year mortgage in 2012, you will still be paying it off in 2041. At that time, you will be making the same payment as you have monthly for the preceding 28 years; but you will be making the payment with 2041 dollars.

So, if there is across the board wage inflation to go with the across the board price inflation, as time goes on you can expect to be paying a proportionately smaller amount of your wages in order to make your monthly payment.

In other words, if you buy a house with a $1000 monthly payment, that might look like a lot to you in 2012, but that same $1000 monthly payment will not look like a lot to you in 2041; it will be pocket change.

The tax deduction really doesn't provide a good reason to take out a mortgage; it just distorts both the supply and demand side of the transaction: causing it to occur at a higher price than it otherwise would and causing people who would not have transacted to go ahead and transact.
posted by Protocols of the Elders of Sockpuppetry at 1:38 AM on January 9, 2012

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