Buying a home is one of the most expensive investments in most peoples’ lives, and therefore selecting the most fitting mortgage type and negotiating a fair purchase price should be paramount decisions. It’s commonly accepted that home buyers can afford mortgages costing up to 30 percent of their monthly incomes, and paying more than that amount may set buyers up for financial hardships.
Buyers who keep their monthly mortgage costs low are typically able to pay their principals down ahead of schedule, saving them interest costs. Some buyers who’ve recently sold a home or have a great deal of savings may opt to purchase a home outright with cash, avoiding mortgage costs altogether. But which approach is the smartest decision for a home buyer?
There is no widely accepted right or wrong answer. The best answer boils down to home buyers’ circumstances and their ultimate goals. Some buyers simply do not want the burden of debt and would prefer to own their homes, sacrificing available cash. Others prefer to invest elsewhere, save for retirement or vacations, while aggressively paying down a mortgage. Each method of purchasing a home has a list of benefits and drawbacks.
First, prepaying a mortgage means a homeowner pays what is owed of his or her mortgage before it’s due. Borrowing money from a lender to purchase a home is the most common practice for purchasing a home, but lenders charge expensive interest rates. Throughout the life of the loan, the price of interest can end up costing more than the price of the home.
To avoid a great deal of the interest charges, home buyers pay extra funds toward their principals, which in turn reduce the amount of interest owed to the lender. Sometimes borrowers pay one or more extra payments per year – one lump sum, add a little extra to each payment or pay a varied amount as budgeting allows. This is one method of getting out of mortgage debt early.
Save on Interest
There are multiple benefits of prepaying a mortgage, beginning with avoiding much of the interest costs. On a $200,000 loan over 30 years with a 4.5 percent interest rate, the borrower pays $164,814 in interest.
If the borrower pays the $1,013 mortgage each month, applying an additional $100 specifically toward the principal, the loan gets paid off five years ahead of schedule and the borrower saves $31,745.71 in avoided interest payments.
Own the Home Before the Mortgage Term Ends
Another draw to prepaying a mortgage, besides the thousands of dollars saved on interest, is loans are paid off sooner. The burden of debt can be overwhelming, and aggressive mortgage payments cause the weight to be lifted earlier.
More Liquidity for High-Interest Debts and Investments
Borrowing money from a lender to purchase a home allows home buyers to use their savings to reconcile higher-interest debts while owning a home. For example, if the buyer has a credit card payment with a large balance and higher interest rate than 4.5 percent, then it’s better to take out the home loan and use savings to pay off the credit card, instead of investing available cash into the home.
If homebuyers do not have outstanding debts but choose to borrow funds to purchase a home, they are able to invest saved cash in more liquid assets with higher returns.
Prepaying a mortgage also means that a person continues to pay for a dwelling whether rented or owned. Therefore, despite the risks of investing in real estate, fully owning a property for as little expense as possible is a positive investment – as it’s an essential investment. Prepaying a mortgage reduces the total cost of fully owning a home.
Prepaying a mortgage is not typically encouraged by the lender and some borrowers are charged a penalty for prepaying their mortgages, which devalues their interest savings. Lenders occasionally include a prepayment penalty disclosure within the loan to protect their interest profits. Other third-party lenders charge homeowners fees for bi-weekly prepayment programs, where they collect bi-weekly payments and then pay the lender monthly.
Neglecting Smart Investments
Instead of paying more than is required toward a mortgage, homeowners could be investing their extra funds in accounts with higher returns. For instance, borrowers could be contributing toward 401k matching programs that might double their funds, but their excess cash is being applied to the home.
Skipping Basic Savings
In addition, smart uses of income that should be prioritized before prepaying a mortgage are creating a savings account to cover at least six months of living costs, retirement savings and paying down higher-interest debts.
Buying a Home With Cash
Some home buyers are fortunate enough to afford writing a check for the entire purchase price of the home, including closing costs. This method of home-buying avoids a mortgage and debt completely. But the buyer should still fund an inspection, appraisal and escrow to ensure the title is clear and the home is a quality investment.
Buying a home with cash lifts the burden of debt from the homeowner. Homeowners are then only responsible for taxes and insurance since interest is entirely avoided, allowing more monthly funds for alternative savings or investments.
Homes purchased with cash are typically taken more seriously by sellers. There is no risk for the seller of waiting for the buyer’s funding to be approved and processed because that process is omitted. A buyer with cash makes for a fast sale with low risk. Therefore, all-cash sales often beat out competition even if their offers are lower.
Purchasing a home with cash allows buyers negotiating power. Sellers view these offers as low risk and quick since they avoid transactions with lenders. Sellers who are anxious to sell their homes often accept lower prices and even offer discounts to entice such offers.
Avoid Lender Fees
All-cash buyers don’t have to qualify for a loan or work with a lender. They don’t have to go through the lengthy loan process. In turn, these buyers pay fewer closing costs. Avoiding the lender’s origination fees and other mandatory charges can eliminate thousands of dollars in closing costs.
100 Percent Equity in the Home
Lastly, buying a home outright is beneficial for the borrower who builds equity in the home.
No Tax Deduction
The first drawback for all-cash buyers is they don’t reap the tax advantages of deductible mortgage interest payments since they do not pay mortgage interest.
Buying a home in cash requires an enormous amount of money, and depending on the buyers’ circumstances, may not be a financially sound decision. Just as aggressively prepaying a mortgage shouldn’t be a priority before building a deep savings account, retirement account or saving for children’s college funds, all-cash buyers need to consider these safe saving obligations before tying up their funds in one property.
Investing such a large sum into a property lessens the buyer’s liquidity to free up cash for other investments and may prevent buyers from saving enough for life’s significant costs.
Reduces Funds for Expensive Home Costs
With so many funds tied up in the property, buyers may not be prepared for the costs of home maintenance. Because homeowners spend between 1 and 4 percent of the total value of their homes in maintenance and repairs each year, a home worth $200,000 might cost $2,000 to $8,000 yearly in repairs. Other home costs that still apply to all-cash buyers are rising property taxes and homeowner’s insurance.
Fees to Obtain a Mortgage Later
Lastly, if the buyer decides to take out a loan on the property later on, there is no seller so he or she is responsible for the closing costs. If the borrower chooses to do a cash-out refinance, the interest rates are higher than a purchase interest rate. Therefore buyers must be certain they can afford to absorb extensive assets into one property all at once, and own that property until they are prepared to sell the home or pay substantial fees.
Overall, prepaying a mortgage and buying a home outright have beneficial advantages for home buyers. The buyers must evaluate their current circumstances: Amount of savings to apply toward a home purchase, total preparation for retirement and depth of emergency fund.
If the ultimate goal is to avoid the charges and burden of a mortgage and their financial circumstance can support it, then buyers might consider buying a home with cash. If buyers have other financial goals in addition to owning a home, then obtaining a low interest mortgage and aggressively prepaying it is a more fitting approach. The selection should be made on a case-by-case basis.