The idea of living without a mortgage can be particularly appealing to people approaching retirement. It is also common today for empty nesters to consider selling the large family home in favor of a smaller property or an easier to maintain condo. Homeowners who have lived in a house for a long time and now have a low mortgage balance or perhaps no mortgage at all may wonder if it pays to buy a new property with the proceeds of the sale in cash. instead of getting a mortgage. Even though early retirees may be reluctant to take on debt until retirement, leverage can pay off.
Leverage is when the expected rate of return on your investment portfolio is greater than the interest rate on a loan. If you can borrow the money for less than what you can reasonably expect to earn by investing the funds instead, then it makes sense to consider the loan. Of course, deciding to buy cash or get a mortgage involves more than the gap between your expectations and current interest rates, but it’s a useful starting point.
Ultra-conservative investors, buyers during periods of high interest rates, or individuals looking for variable rate mortgages may find it more difficult to operate leverage for them with a reasonable level of certainty.
Here is an example :
Suppose the Millers, aged 60, sell their house for $ 700,000 and their mortgage payment is $ 200,000. They plan to buy a condo for $ 500,000 and put 20% into it. The Millers can get a 30-year fixed mortgage at an interest rate of 4.5% and their expected average annual return on their long-term investments is 6%. The couple plan to work until the age of 66.
If they get a mortgage, they will make the mortgage payments out of their income while they are working. Without a mortgage, they will invest the funds instead. If they retire with a mortgage, the Millers will use their investment account for payments after they stop working.
The question is: should they get a mortgage or buy the new home with the cash proceeds from the sale of their old home?
In this example, it is better to use leverage. Thanks to the power of compounding, after 30 years, the Miller’s investment account would be almost $ 260,000 higher if they bought the house with a mortgage than if they paid for the condo in cash, tax-free.
It is useful to note that many variables in this analysis are correlated. If the Millers increased their purchase price, the benefits of getting a mortgage would also increase. However, if the spread between current mortgage interest rates and expected returns on investments narrows, the benefits of getting a loan will diminish.
A complex analysis
Unless you’re comparing a fixed rate mortgage to owning a 30-year bond, homebuyers need to make several key assumptions for the analysis. Since there is no way to know for sure what will happen in the future, it is important to consider all aspects of the decision.
Here are some additional financial considerations:
- Taxes. Homeownership offers tax benefits and a mortgage plays a key role in realizing these benefits. Taxpayers who itemize their tax deductions can usually deduct mortgage interest on the first $ 750,000 of primary or secondary residence debt, although there are other considerations as a result of the tax reform legislation. of 2017. This can be particularly useful for retirees who have lost many of their other options for reducing their taxable income (eg 401 (k) contributions). While tax implications are an important part of any financial decision, it’s important not to let the tax tail wag the dog – laws can change at any time.
- Market volatility. Even if an investor makes an average annual return of 6% (as assumed in the example above), the actual return will vary significantly from the average for any given year. The order in which the returns occur can have a huge impact on the result of the scan. For example, in Miller’s case, if their rate of return was -4% in the first year and 6% for the remainder of the 30-year analysis, the benefit of getting a mortgage would be reduced to 56. 000 $, against 260 000 $! Likewise, if the market outperformed the average return in the first year of the simulation, the relative advantage of getting a mortgage versus buying cash would increase.
- Variable rate mortgages. An ARM alters the analysis a bit as more complexities and unknowns are introduced. An adjustable rate mortgage is generally more beneficial when the owners do not plan to live in the home for much longer than the initial fixed period. In this situation, buyers will also need to consider the likelihood of staying in the home longer than expected, how rate increases are determined, and their expectations for future interest rates. While the risk is heightened, when an ARM is appropriate, this is a great example of using leverage.
Practical Considerations When Buying a Home
Buyers may also face logistical challenges or the pressure of a competitive market. Especially for people who have lived in their homes for a very long time, decluttering, downsizing, and moving can be quite a challenge. Unless you can negotiate a sale-leaseback, or manage to align the two house closings perfectly, cash buyers may be forced to stay in a hotel or rent during the interval.
Obtaining a mortgage loan may ease the transition for some buyers who already have a down payment and are still eligible for their loan while carrying both homes, as they may be able to buy a new house before selling the old one. Convenience comes at a price though, and there is a risk that the home won’t sell as quickly or at the price you expect.
All cash offers are the preferred tool of buyers in competitive markets. If a mortgage is preferable but you are struggling to compete with unconditional offers, one option might be to buy the new home or condo with the cash proceeds from the sale of your old home and apply for a loan afterwards. fence.
While buying or selling a home is an emotional decision, it’s important not to let your personal feelings cloud your better judgment. Buying too many homes or deciding to buy cash just because you can could slow down your retirement lifestyle in the long run.