April 29th, 2019 6:55 AM by Jackie A. Graves, President
The idea of living mortgage-free can be
particularly enticing for individuals nearing retirement. At this time, it’s
also common for empty-nesters to consider selling the large family home in
favor of a smaller property or condo that’s easier to maintain. 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 consider whether it’s advantageous to buy a new
property with sale proceeds in cash instead of getting a mortgage. Although
pre-retirees may be hesitant to carry debt into retirement, the leverage can
Leverage is when your expected rate of return on your investment
portfolio is greater than the interest rate for a loan. If you can borrow money
for less than an amount you can reasonably expect to earn by investing the
funds instead, then it makes sense to consider the loan. Of course, deciding
whether to buy with cash or get a mortgage involves more than the spread
between your expectations and the current interest rates, but it’s a useful
investors, buyers during periods of high interest rates, or individuals seeking
variable rate mortgages may find it more difficult to make leverage work for
them with any level of reasonable certainty.
Here’s an example:
Assume that the Miller’s, age 60, are selling their house for
$700,000 and their mortgage payoff is $200,000. They’re planning to buy a condo
for $500,000 and put 20% down. The Miller’s can get a 30-year fixed mortgage
for 4.5% interest and their expected average annual return on their investments
over the long-term is 6%. The couple plans to work through age 66.
If they obtain a mortgage, they’ll make the mortgage payments
out of their income while they’re working. Without a mortgage, they’ll invest
the funds instead. If they retire with a mortgage, the Miller’s will tap their
investment account for the payments once they stop working.
The question is: should they get a mortgage or purchase the new
home with the cash proceeds from the sale of their old house?
In this example, it’s best to use leverage. Through the power of
compounding, after 30 years, the Miller’s investment account would be nearly
$260,000 greater if they bought the home with a mortgage compared to if they
paid for the condo in cash, excluding taxes.
It’s helpful to note that many of the variables in this analysis
are correlated. If the Miller’s increased their purchase price, the benefits of
getting a mortgage would also increase. However, if the spread between current
mortgage interest rates and expected investment returns narrows, the benefits
of getting a loan will shrink.
Unless you’re comparing a fixed mortgage to holding a 30-year
bond, there are several key assumptions that homebuyers must make for the
analysis. Since there’s no way to know with certainty what will happen in the
future, it’s important to consider every aspect of the decision.
Here are some additional financial considerations:
has tax benefits and a mortgage plays a key role in realizing those benefits.
Taxpayers who itemize their tax deductions can typically deduct mortgage
interest on the first $750,000 of first or second home indebtedness, though
there are other considerations following the 2017 tax reform legislation. This
can be especially valuable for retirees who have lost many of their other
options to reduce their taxable income (e.g., 401(k) contributions). Though tax
implications are an important part of any financial decision, it’s important
not to let the tax tail wag the dog: the laws can change at any time.
volatility. Even if an investor realizes an
average annual return of 6% (as assumed in the example above), the actual
return will vary considerably from the average in any given year. The sequence
in which the returns occur can have a dramatic impact on the outcome of the
analysis. For example, in the Miller’s case, if their rate of return was -4% in
year one and 6% for the rest of the 30-year analysis, the benefit of getting a
mortgage would be reduced to $56,000, down from $260,000! Similarly, if the
market were to outperform the average return in the first year of the
simulation, the relative advantage of getting a mortgage versus buying
with cash would increase.
rate mortgages. An ARM changes the
analysis a bit as additional complexities and unknowns are introduced. An
adjustable rate mortgage is usually most advantageous when homeowners don’t
plan to live in the house for much longer than the initial fixed period. In
this situation, buyers will also need to consider the likelihood of remaining
in the home longer than expected, how the rate increases are determined, and
their expectations of future interest rates. Although the risk is increased,
when an ARM is appropriate, it’s a great example of using leverage.
considerations when buying a home
Buyers may also face logistical challenges or the pressure of a
competitive market. Especially for individuals who have lived in their home for
a very long time, decluttering, downsizing, and moving can be quite a
challenge. Unless you can negotiate a sale-leaseback, or manage to perfectly
align both home closings, cash buyers may be forced to stay in a hotel or rent
during the gap.
Getting a mortgage may make the transition easier for some
buyers who already have a down payment and still qualify for their loan while
carrying both homes, as they may be able to buy a new home before selling their old one.
Convenience has a price though, and there’s a risk the home won’t sell as
quickly or at the price you expected.
All cash offers are the preferred tool for buyers in competitive
markets. If a mortgage is preferable but you’re struggling to compete with
noncontingent offers, one option might be to buy the new house or condo with
the cash proceeds from the sale of your old home and apply for a loan after
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 much home or deciding to purchase with cash solely because you can could
dampen your retirement lifestyle in the long run.
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