The “Other People’s Money”
If you are thinking about paying cash for a home you may want to reconsider. Its true, Paying cash for a home does make sense when a buyer is negotiating to purchase a home. Buyers who present offers with a quick close and no mortgage or other contingencies have a much greater chance of their offer being accepted over another offer that has a mortgage contingency.
On the other hand, it may not make investment sense for a buyer to pay cash for a home when mortgage rates are at record lows. For the month of November, the nationwide average was 3.3 percent. Consider the following:
The Morgan’s are purchasing a home for $500,000. Instead of paying cash for the home, they obtain a mortgage with a fixed-rate of 4% to buy the home. They take their cash and invest it with their financial advisor.
The Morgan’s are getting a return on their investments of 7%. If they pay 4% for the money they’re borrowing from the bank, and re-invest the money and get a return of 7%, they can pocket the difference of 3%. That may not seem like a lot of money, but it turns out to be $500,000 x 3% = $15,000.00 every year.
If the Morgan’s keep the home for 10 years, and their investment portfolio continues to pay 7%, the Morgan’s will realize $15,000.00 per year x 10 years = $150,000.00. If they pay cash for the home, the $150,000 is never realized.
In the best case scenario, the Morgan’s could realize an even greater return from shrewd investing that pays more than 7%. This strategy is called “using other people’s money.” It is used by the banks all the time. Banks will offer savings or CD accounts for as little as 2%, then turn around and offer mortgages at 4-5%, and pocket the difference.
Given the likelihood of higher investment returns in the future, it makes a great deal of sense to secure loans at 4% and keep those loans in place for as long as possible. Every buyer should give careful consideration to financing their purchase by discussing this option with their financial planners or financial advisors.
One last point, if this strategy makes sense don’t plan to prepay your mortgage as your profit by investing the difference is likely very substantial.