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21 Sept 2015

PAYING CASH FOR A HOUSE

The reader's email below on getting a homeloan and paying it up quicker or paying cash for a house made me think a bit. All I can do is give the pros and cons of each option. I have done all three when I was trying to find my spot in the real estate space.
Kitchenette plan for the new student accommodation
Here goes our question:
Hey Mbini

Hope your are well.

I just wanted to get your take on ways in which one should pay for a house. Would you advise a new home buyer to get a home loan or pay the house cash if they have the money? And if one opts for a home loan would you advise they pay it off as quick as possible?

Thank you
I love your BLOG!!
Thanks for your question Miss P. This blog is keeping me sane on so many levels. I am currently busy with my biggest renovation so far and have limited time to write. All my free time is spent shopping for building material and drawing layman plans. I will share details of acquiring and adding value to this property hopefully soon. I find your questions much more interesting and thought provoking than my soapy mortgage and dust sniffing stories. With my current schedule I only find quiet time to write just before bed. I am very glad that more than a few people benefit from my writing. This blog is my happy space.
Back to the question at hand: Getting a mortgage and paying it up quicker versus paying cash for a house.

Option 1: Paying Cash for a House
Taking a simplistic view to this option can lead to a conclusion that it is the cheapest way as one saves on the interest that would be paid on the homeloan. The major benefit of this option could be more mental than financial. Knowing that one owns the property fully can afford them peace of mind. Peace of mind cannot be taken lightly. Let's face it, it is a nice feeling not having to pay for any monthly installment. I have enjoyed not having a homeloan each time I had none. I may never ever enjoy that ever again but it sure is a nice feeling.  I especially prefer not having a homeloan on my primary residence as its debt attracts no tax benefits.

The other advantage of paying cash is the bargaining power it affords one. It is a fact that all sellers would prefer to sell to the cash buyer. You can easily make a ridiculously low offer as a cash buyer and have it accepted. Its true that "cash is king".
Just the other week my agent got a bargain piece of development land at R1.2M asking price. Within a few days the seller got a cash offer to purchase for R800k. He immediately told my agent that he is not looking at any new offer that is not cash and will be selling to the R800k guy if he does not get a better cash offer. Sellers  don't want the stress of the buyer not being able or taking too long to secure a mortgage, changing their mind, etc. cash buyers often get better deals. These benefits make paying cash for a house seem to be the most attractive option.

Option 2: Getting a Home Loan and Paying it Faster
Option 1 does look great, however financial life is more complex than that. There is never a simple YES or NO solution  to any investment decision. There are a lot of factors involved when taking wealth building decisions. The most important of those factors being the opportunity cost. The dictionary definition of the opportunity cost is "the loss of other alternatives when one alternative is chosen". One has to consider a number of alternatives that would have been explored with that amount of cash if it were not tied to the home investment.

I will make an example of a R1M (R1,000,000) house paid for in cash. And just to be realistic for current South African interest rates, I will look at the 10% homeloan interest. If your home is paid for in cash, it is paid for and that is it. You save about another R1M in interest that you would have paid over the homeloan period of 20 years at 10% and gain some more in capital growth of your home. You also save a bit in interest if you get a mortgage and fast track its payment.

Lets now look at the case where the same R1,000,000 (R1M) would have been saved in a bank account (investment) or bond that earns 10% in interest. Remember that those are more secured, which makes our calculation a bit more realistic compared to using a higher risk and higher return investment. Over the 20 years period your R1M would turn to just above R7,328,000 (R7.3M). You and I know that you can do better if you use a stocks related investment vehicle. (I am not going to complicate this equation by factoring in the alternative shelter variable, sorry.)

The only difference here is that with your home paid for in cash, your money is tied into one illiquid asset. Whilst saving or investing your R1M in one or more other more liquid asset classes may offer more risk combating benefits.

Option 3: Deposit a Few Properties
Ok, I had to throw in this third option. It is the approach that I would personally take based on my own focus strategy. Paying cash for a house is something I have done a few times in my early days by the way. Whilst it gives this priceless feeling, not taking advantage of the power of leverage does not sit well with most property investors. I would take the R1,000,000 and get into serious real estate debt. It would probably be my 20% equity to acquire R5,000,000 worth of investment property. Using it as a 10% equity to a R10,000,000 (R10M) worth of investment property sounds even better. Oh well, that is just me. This approach carries tons of risks. But those risks are shared with the lending institution.

I will revisit blogging on building wealth through "the power of LEVERAGE". My latest acquisition with no deposit or down payment is a great example of this.

One needs to do a lot of research before investing their hard earned cash. If one has no clear focus strategy, they should invest in education, a mentor or a coach. In the previous post  on Building Wealth I was looking at a simple three phase approach on creating and growing wealth.

 Note:
Thanks for the amazing emails. I respond to each and every email I receive. I keep all emails anonymous when I  respond to them through this platform. Feel free to make a follow up question or comment using the "Contact Us" button above.

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8 comments:

  1. Thank you very much for this article. My wife and i are looking to buy a home, we are incredibly lucky to have the opportunity to buy the home cash but seeing as there are definitely other options that could yield better returns when investing, we are going to investigate all options. Thank you for the advice and knowledge!

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  2. Pleasure Kyle. All the best to you and your wife.

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