Investing in Real Estate: Cash vs. Leverage
In today’s environment of rapidly rising interest rates, the idea of signing up for a mortgage seems increasingly infeasible for the average person. In the past few months alone, the average monthly mortgage payment has increased more than 50%. On a $500,000 mortgage, the difference in interest between 2021 interest rates and today’s interest rates across the lifetime of a loan is more than $400,000. What average American can afford to give up an additional $400,000? Yet the billionaires of the world choose to take on mortgages like these and put this leverage to their advantage. Why would they choose to do such a thing and what makes the most sense to do for you?
Today, the focus will be on taking out a mortgage versus simply using cash and skipping the lender altogether when purchasing a home. We thought it would be in the interest of our readers to explore both sides here.
Of course, it’s not that simple for the majority of the population to throw a few hundred thousand dollars (or more) down on an all-cash property purchase. So for many, this won’t even be an option, but, maybe, it will be soon (spoiler alert: Google search Homebase). In the meantime, we’ll have to make do with either buying all-cash or taking out a mortgage.
Buying a Home with Cash Has Its Benefits
First, let’s talk about buying a home with all cash. This is the preferred approach of real estate investors and the mega-rich, though billionaires like Mark Zuckerberg still take out mortgages.
But for a majority of the population, this cash or mortgage question doesn’t even exist because most of us can’t afford to buy a home with cash.
For those who are lucky enough to be able to choose, there are advantages to buying a home with cash as opposed to taking out a mortgage.
Advantages to Buying a Home with Cash
#1: No Need to Qualify and Shop for a Mortgage
One of the first advantages of buying a home with cash is that you don’t need to qualify for a mortgage. By coming to a seller with cash on-hand, you skip the middle man that will analyze your trustworthiness based on a credit score, citizenship, and assets. You can simply approach a seller and make a deal.
#2: No Mortgage Payments and No Interest Due
As previously mentioned, at current interest rates, mortgage payments and interest have skyrocketed astronomically in the past few months. So, paying in all cash lets a buyer avoid getting locked into expensive, long-term debt. This is great for those who have lost their job or are close to retirement as it provides a sense of security over an asset that you 100% own. Just invest then set-it-and-forget-it.
#3: No Lender Fees
A beautiful thing about paying with all cash is skipping the lender fees. These can include but are not limited to:
- Application fee
- Attorney’s fees
- Broker fee
- Discount points
- Origination fee
- Prepaid interest
- Processing fee
- Title search fee
- Underwriting fee
The combination of the lender fees and closing costs can often exceed 4% of the amount of the loan. Ouch. That’s not to say that there aren’t closing costs associated with cash purchases, but, at least with an all cash purchase, buyers can skip these fees and focus on just buying the asset.
#4: Financing is Always Still an Option
For everyone, situations can change. Homeowners certainly can change their mind as well, whether that’s due to shifting circumstances or because there are other great opportunities abound. For homeowners that buy all-cash, access to financing to tap into liquidity can be done through a home equity loan or delayed financing. These options aren’t necessarily ideal in their terms, but still, as a cash buyer, you reserve the right to choose.
#5: Negotiating Power
Simply put, cash buyers have more negotiating power than mortgage buyers. In the following chart, you can see the added effectiveness of different strategies to couple with an offer on a home.
Paying in all cash gives cash buyers negotiating power in competitive markets, resulting in lower purchase prices and faster closing. If you’re going up against some other would-be buyers that need to finance the purchase with a home loan, you’ll have the upper hand in pretty much every situation when paying cash.
Put yourself in the shoes of a seller looking to access liquidity by selling their home. The added costs, headaches, and delays associated with working through a mortgage provider in order to receive the proceeds of selling a home is less attractive than receiving cold, hard cash.
Sure, you could get outbid by another buyer willing to offer more for the home, but your cash offer should be king if all else is equal.
Taking Out a Mortgage, Even If You Don’t Have To
On the other hand, what is widely considered the traditional approach to buying a home, is that of a debt-financed home purchase, or a mortgage.
Taking out a mortgage is the default option more out of necessity than preference. Most of us can’t afford to buy real estate with cash. We need a mortgage to leverage ourselves and our record of trustworthiness in order to increase our purchasing power.
Even for the rich, mortgages can be the preferred choice. For many working in the real estate industry, there is a belief that investing without leverage is not even feasible.
But why? Let’s dive into the advantages of taking out a mortgage.
Advantages to Buying a Home with a Mortgage
#1: Using Bank-Sponsored Leverage
As alluded to previously, mortgages increase purchasing power. Lenders calculate purchasing power as a function of one’s assets and credit score as well as current interest rates, allowing investors to purchase assets that they normally could not access with just cash. Additionally, mortgages are cheap compared to almost every other type of loan out there, and can be locked in for a full three decades, even at today’s rising interest rates. A home loan with a 3% mortgage rate that is fixed sure sounds better than a credit card’s APR at 20% or higher, which is often variable, meaning it is at the discretion of the provider.
#2: Inflation Makes Future Monthly Payments “Cheaper”
Inflation is such a hot button topic these days, and it should be. With the price of goods rapidly inflating, it’s hard to ignore the magnitude of inflation in our everyday lives. To combat inflation, there is beauty in investing via a mortgage. A mortgage will lock in buyers at a fixed interest rate for thirty years. If you purchase that $500K home, you will pay $3,000 per month for the next thirty years. While some may argue this is a negative, with real estate prices and rents historically going up over time (in the long run), paying a fixed amount for an appreciating asset can actually be a very wise investment.
#3: A Mortgage Can Actually Improve Your Credit Score
As mortgages are a debt instrument, credit is inherently tied. While credit is essential to receive a mortgage to begin with, consistent, on-time payments for a mortgage can show a solid body of credit and trustworthiness for any individual’s credit score. Over time, additional mortgages and forms of credit including credit cards and car loans can improve credit scores and give individuals that 800 credit score they’ve been chasing after.
#4: Tax Advantages
Another wonderful aspect of mortgages is the ability to take tax advantages from a mortgage. The US tax code was designed to incentivize home ownership and the use of financial instruments. With a mortgage, you can write off all mortgage interest if your itemized deductions exceed the standard deduction. So even though mortgage payments are cursed with interest, paying off interest can result in a lower tax bill each April when Uncle Sam comes knocking.
#5: You Only Need to Bring in a Small Down Payment
The third advantage of using a mortgage is the fact that you only need to bring in a small down payment. This allows buyers to invest in one asset with their cash on hand and invest their money elsewhere for a (potentially) better return. At a 7% interest rate at the time of publishing this article, it’s certainly possible to beat a 7% annual return in the market or elsewhere, which explains why the ultra-rich elect to take out mortgages.
A leveraged payment also provides less financial risk if something happens to your home or if values drop and lets investors invest in riskier assets to pair with their home investments. On the other side of the coin, if you’re a conservative investor, leverage payment allows you to only risk a portion of your portfolio so you can invest in less risky assets or sit on that cash for a rainy day. No shame in avoiding putting all of your eggs in one basket.
How Can You Get the Best of Both Worlds?
Okay so which one is better? Simply put, you have to pick the one that works better for your financial goals and what you can afford to risk.
But what if I told you that there is a third option?
In other words, what if I told you that you could pay all cash but still take advantage of leverage.
A Better Alternative: Not Cash, Not Bank Leverage, Community Leverage
Enter Homebase. With Homebase, you’ll be able to invest in the highest quality residential real estate to take advantage of cash flow, appreciation, and tax benefits, without having to choose between cash and bank leverage. With Homebase, you can take advantage of community leverage, or a shared investment in real estate, so investors can invest with the power of cash while skipping out on the high barriers to entry of conventional mortgages. If you want to read more, check out our previous article, The Influence of Interest Rates on Homeownership.
Through Homebase, you can build wealth like a millionaire, without having to sell your soul (sorry Mark).
To see what we’re building and sign up for early access, check us out at https://homebasedao.io/.
Thanks for reading!
Alex, Homebase Co-founder