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Prepay a Mortgage or Buy a Home With Cash?

October 16, 2013 10 Comments

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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.

Buying home with cashBuyers 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.

Prepaying Mortgage

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.

Benefits

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.

Necessary Investment

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.

Drawbacks

Additional Fees

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.

Benefits

Debt Free

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.

Competitive Buyers

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.

Negotiable Discounts

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.

Drawbacks

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.

Lessens Liquidity

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.

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Comments

  1. Beat The 9 to 5 says

    October 16, 2013 at 9:04 AM

    My choice between prepaying and buying outright with cash, will always depend on my financial capability. It’s always better to make a proper evaluation before making a choice and to consider other expenses.

    Reply
  2. Lance @ Money Life and More says

    October 16, 2013 at 9:42 AM

    My biggest concern with paying cash would be liquidity and opportunity cost with today’s low interest rates. Maybe when mortgages were 12% it would make sense to pay cash but I wouldn’t today.

    Reply
  3. getrichwithme says

    October 16, 2013 at 12:04 PM

    I think Lance has the right thoughts
    Why would you want to over repay a mortgage during periods of low interest rates when the markets are averaging 9% a year.
    Its a sort of Arbitrage
    Borrow the money at 3% and invest it for 9% over a period of time you win.
    Also the markets are a great hedge against inflation, whereas inflation reduces the true value of a debt. Inflation can be a win win for investors with a mortgage

    Reply
  4. [email protected] says

    October 16, 2013 at 12:18 PM

    You make some great points.But I think I’d definitely spend cash on an investment property. I’m not sure I would I would for my own home. Writing a check for all that money would be painful.

    Reply
  5. midlifefinance says

    October 16, 2013 at 12:33 PM

    I’m with Lance too. Why lock up all your liquidity in your house? I think we should pay off our home before retirement, but there is no hurry until then.

    Reply
  6. Jacob | iHeartBudgets says

    October 16, 2013 at 12:59 PM

    Liquidity would be my main concern, though a home equity line of credit could take care of that. But you’re right, there are pros and cons to both, but MOST buyers don’t have the capability to purchase a home cash, but CAN prepay their mortgage.

    Reply
  7. Bryce @ Save and Conquer says

    October 16, 2013 at 1:53 PM

    Good comprehensive article. The only thing I would add is that it is usually wise to payoff the mortgage before people retire. Retirees living off their assets are often better off without having to make mortgage or rent payments. It doesn’t change your article, it just means there could be another reason for prepaying the mortgage or buying with all cash, and that reason is the person’s age and time to retirement.

    Reply
  8. Matt Becker says

    October 16, 2013 at 3:30 PM

    If I purchased a home with today’s interest rates, I would not be in a rush to pay it down. I would expect my investments to make more over the long term and, as another commenter noted, keep up with inflation. In the end the odds are higher of coming out ahead that way.

    Reply
  9. krantcents says

    October 16, 2013 at 8:19 PM

    Normally, I believe in mortgages and leveraging your down payment unless your real estate investment is growing at a high rate, I would rather invest excess cash in other investments. I earn a better return and at 2-3% interest rates and the IRS subsidy, it makes more sense to invest elsewhere, My one caveat is if you are satisfied with your return. Real estate cannot be sold easily and it is a long term investment.

    Reply
  10. Tushar @ Everything Finance says

    October 22, 2013 at 10:25 PM

    It would definitely be nice to buy a house with cash, but that can be difficult if you live in an expensive area. We are pre-paying our mortgage as fast as possible. Mortgages can also allow you to take advantage of a good market when there is one, which you wouldn’t be able to do if you didn’t have the cash at the time and wanted to jump on the opportunity.

    Reply

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