Why do people use mortgages, when they could just pay for the house in full?

Question

I would like your recommendation on whether you should buy a house with a mortgage, which you would pay as you go, or should you buy it in full.

Very few people have the opportunity to buy a home for cash. However one should note, that in the USA, about 33% of properties are owned outright. So many people are either paying cash, or paying down the mortgage as fast as possible. — Pete B., Oct 22 '18 at 14:21

score 36 · Answer 1 · edited May 12 '20 at 18:04

36

Good question.

If a person has a choice, it is probably better to pay cash. But not always.

If your large pile of cash can earn more being invested than cost of the interest to borrow a similar large pile of cash, it is beneficial to get a mortgage. Otherwise pay cash.

EXAMPLE:

A house costs $100,000. I have $100,000 in extra money. I can invest that at 5% per year, and I can borrow an additional $100,000 at 2% per year. Since I can make more on my pile of cash than it costs to borrow another pile of cash, borrowing is better. Compound interest is the most powerful force on the planet according to Albert Einstein (maybe).

That isn't likely for most people though.

Here is the results from some online financial calculators.

http://www.calcxml.com/do/hom03 Borrowing $100,000 with 2% interest for 30 years will cost a total of $148,662. You get $100,000, but it cost you $48,662 to do it.

http://www.calcxml.com/do/sav07 Saving $100,000 in a bank account with an interest rate of 5% will be worth $432,194 in 30 years. By not spending the money you will earn $332,194 over the course of 30 years.

So if you can invest at 5% and borrow at 2% you will end up with $283,532 more than if you didn't.

It is a pretty extreme example, and financial advisers make a lot of money figuring out the complex nature of money to make situations like that possible.

edited May 12 '20 at 18:04

yoozer8

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answered Dec 30 '09 at 22:51

MrChrister

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+1 but bear in mind whenever comparing saving and borrowing rates your tax liability. If you pay 40% tax that 5% interest rate becomes 3% nett, and much less attractive – Rich Seller Dec 30 '09 at 23:35
Very true. All I know for sure is there is a lot of the details I don't know. – MrChrister Dec 30 '09 at 23:38
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I want to know where you are investing and receiving a 5% return. :) – Ether Nov 13 '10 at 17:46
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Not to mention getting a 2% mortgage rate. – Kyralessa Jun 22 '11 at 23:34
Plus, mortgage interest is tax deductible, so that closes the gap too. But the general idea, you may make more money by borrowing money now.
Oops, I mean the tax deduction helps the borrow case, and may balance out the tax bill of interest income - as mentioned by Scott W.
– Andy Wiesendanger Jun 27 '11 at 18:50
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Mortgage interest is only tax deductible in some countries. It is not generally tax deductible in Canada, for example. See http://www.planyourescape.ca/is-your-mortgage-interest-tax-deductible-76 – ChrisInEdmonton Jun 28 '11 at 20:07
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Don't forget risk. Ask yourself - If you had a paid off, $200,000 house, would you go borrow $200,000 on it to put into the stock market? 999 times out of 1000, the answer is no. – NPFinance Nov 26 '12 at 14:25
You also tend to benefit from inflation when you take the loan. Although not ensured, currency tends to devalue over time due to inflation so each dollar you use to pay the loan back is less valuable, in some sense, then the dollar that you got from the loan. By itself this won't be enough (we hope), but combined with tax advantages, the potential to invest, and other things in the answer, it contributes to the possibility that the loan is worth it. – Mar 25 '16 at 20:41
You have mixed using '.' and ',' as the separator in "Borrowing $100,000 with 2% interest for 30 years will cost a total of $148.662." Either that or I really want to know where you get your home loans. – Tashus Oct 22 '18 at 20:25

Tom Au · Answer 2 · 2016-03-25T20:25:55.257

The advantage of using a mortgage is that you pay for a house at TODAY's price, using TOMORROW's money.

Your question suggests that you rightly observed that it was not a good idea around 2006 (the last peak in housing). That was when prices were at their maximum, and had nowhere to go but down. Some experts think that house prices STILL have further to go on the downside. Meanwhile, wages have been going nowhere during that time.

This phenomenon seems to happen about every 40 years or so, the 1930s, the 1970s, and around 2010.

At MOST other times, say the 1980s, houses are likely to go up for the "foreseeable" future. At those times, you want to buy the house at "today's" price, then pay for it in future dollars when you are earning more money.

The irony is that what most people observe as teenagers is usually the wrong thing to do when they are, say, forty. In 2035, it will probably make sense to have a large mortgage in a bull housing market, which is the opposite of what you observed around 2010. So a better rule is to do at age 40 what made sense about the time you were born (in your case, perhaps the 1990s). Whereas the people born in the early 1970s that got "caught" recently, observed the bull market of the 1980s and 1990s in THEIR teens and twenties, rather than the bear market of the 1970s that took place about the time they were born.

score 17 · Answer 3 · answered Jun 18 '10 at 17:52

17

Besides all of the other answers, I will point out that many people simply don't have enough cash sitting around to buy a home outright. It would take many years (or even decades) for the average family to accumulate the necessary cash.

Also, while you are pinching your pennies for years in an attempt to save up for your dream house, remember that inflation is steadily driving up the cost of goods and services. A house that costs $200K today could cost $230K in 5 years due to inflation.

answered Jun 18 '10 at 17:52

myron-semack

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for having the cash sitting around. But as for inflation: that's why you invest your savings in something that'll match inflation, and that's why the lenders have already priced anticipated inflation into your interest rate. It's all about the same in the end.

Jun 22 '10 at 04:14

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Investing into something that matches inflation may require that you are willing to accept some volatility. Currently, most "safe" investments like T-bills and high-yield savings accounts are returning less than inflation. And that's not counting taxes. – myron-semack Jul 08 '10 at 20:07

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A great number of people with substantial retirement savings have more than enough to pay off the remaining mortgage of the house they've owned for decades but will not pay it off because they don't wish to commit money on which they earn ~ 5% to pay off a 3% mortgage. – chili555 Mar 25 '16 at 20:40

This doesn't answer the question. – Mar 26 '16 at 18:17

score 13 · Answer 4 · edited Oct 22 '18 at 14:21

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Some countries, like the United States or The Netherlands, allow a mortgage interest tax deduction. This means the interest you pay on a mortgage, which is typically much more than half of the monthly payment at the beginning of a 25 year mortgage, is tax deductible, so you might get 33% or more of the interest back, and that effectively makes the interest rate significantly lower. Therefore you are borrowing the money really cheap. That makes MrChrister's answer even more appropriate.

edited Oct 22 '18 at 14:21

answered Dec 31 '09 at 04:14

Scott Whitlock

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In the US, the tax deductibility of mortgage interest only becomes relevant if you itemize your deductions. This was common before the 2017 changes to the tax code, but under current US tax law most homeowners are better off taking the standard deduction instead of itemizing. Therefore, unless you have a lot of other deductions, you shouldn't factor tax deductibility into your decision about getting a mortgage. – Nobody Apr 22 '22 at 14:22

score 11 · Answer 5 · answered Nov 25 '12 at 03:32

A $100K house and $100K are not equivalent assets.

Here's a hypothetical...

You and I both work for the same company, and both get a $100K bonus (yes, I said it's hypothetical).

You decide to use the $100K to pay off your house. I put the money in the bank. Six months later, our company lays both of us off.

I have $100K in the bank. I can last for quite a while with that much money in the bank. You have a house, but you can't get a mortgage or home equity loan, because you don't have a job. The only way you can access the money is by selling the house, which requires you to pay money to a real estate agent and perhaps taxes, and leaves you looking for a place to live.

That assumes there isn't something systemic going on - like the credit crash - and there is credit available for somebody else to buy your house.

Maintaining liquidity as you point out is a very important aspect. — Eric Johnson, Mar 25 '16 at 22:22
Instead of selling the house, i'd just rent out the house and that way I would have some income. — Arya, Nov 27 '18 at 06:05

score 5 · Answer 6 · answered Dec 31 '09 at 09:40

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I believe the reason is because society and the economy is set up a certain way, and re-enforced by the government.

Your options are:

Rent a place to live, which is ridiculously expensive because houses are expensive.
Buy a house with cash, but it likely won't happen because houses are expensive.
Get a mortgage and at least have your money invested in something, because renting is paying money toward something you don't own.

So, people usually go with the most attractive of their limited options, getting a mortgage. If you want to dig deeper, do some research as to why housing is expensive. Some things to consider: you need the government's permission to build houses, thus limiting the competition in the home building market, the housing bubble, artificially setting house prices, etc.)

To summarize: people need mortgages because houses are expensive, and houses are expensive for many reasons, big ones having to do with the government.

answered Dec 31 '09 at 09:40

Blaine Lafreniere

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Note: it is a fallacy to assume that buying is better than renting. It entirely depends on the market conditions in your region, the state of the economy, and your ability to pay. In many cities it can be more worthwhile to rent than buy -- there are rent vs. mortgage calculators available to help you determine what is right for you. – Ether Aug 13 '10 at 18:04
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This is mostly a good answer, but I really doubt whether government intervention is a primary driver of mortgages. Houses require a very large amount of materials, labor, and capital in the form of land. Even if gov't distortion is driving up the cost of housing by a factor of 4 (which would be immense), the cost of a typical house in many parts of the world would still bee $100,000-$200,000, which is way more than most people will ever have in cash. – JSBձոգչ May 14 '11 at 14:13
Usually, it is good to buy if your mortgage approximates what you would be paying in rent, because you will build up equity. But if your mortgage is MUCH higher, then you should "rent and invest the difference," to take off on Arthur L William's dictum about term versus whole life insurance. – Tom Au Mar 25 '16 at 20:28

keshlam · Answer 7 · 2016-08-13T03:50:34.967

Condensed to the essence: if you can reliably get more income from investing the cost of the house than the mortgage is costing you, this is the safest leveraged investment you'll ever make. There's some risk, of course, but there is risk in any financial decision.

Taking the mortgage also leaves you with far greater flexibility than if you become "house- rich but cash-poor". (Note that you probably shouldn't be buying at all if you may need geographic flexibility in the next five years or so; that's another part of the liquidity issue.)

Also, it doesn't have to be either/or. I borrowed half and paid the rest in cash, though I could have taken either extreme, because that was the balance of certainty vs.risk that I was comfortable with. I also took a shorter mortgage than I might have, again trading off risk and return; I decided I would rather have the house paid off at about the same time that I retire.

Why do people use mortgages, when they could just pay for the house in full?

7 Answers7