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 pay off.
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 starting point.
Ultraconservative 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.
A complex analysis
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:
- Taxes. Homeownership 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.
- Market 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.
- Adjustable 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.
Practical 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 closing.
While buying or selling a home is an emotional decision, it’s important not to let your personal feelings cloud your better judgement. Buying too much home or deciding to purchase with cash solely because you can could dampen your retirement lifestyle in the long run.
This article was written by Darrow advisor Kristin McKenna, CFP® and originally published by Forbes.